The UniCredit Macro & Markets 2020-21 Outlook · 2019-11-26 · Macro & Markets Outlook November 2019 Macro & Strategy Research UniCredit Research page 4 See last pages for disclaimer

November 2019

The UniCredit Macro & Markets 2020-21 Outlook

Macro Research 21 November 2019 Strategy Research Credit Research

Late-cycle blues

■ Macro: Global growth is set to weaken further to 2.7% in 2020, as the US economy is likely to enter a downturn,

protectionist tensions are unlikely to fade materially and the resilience of the domestic drivers of eurozone growth

starts to wane. The Fed will probably cut rates by 100bp, while the ECB is expected to stand pat and focus on its

policy review. Economic growth in the CEE region will likely slow as a result of external headwinds.

■ FI: Government bonds should remain supported throughout 2020. We expect 10Y US yields to fall to 1.50%, with the

curve bull-steepening. Room for lower Bund yields is more limited as the bar for further ECB rate cuts is high and the

Bund curve is quite flat. The 10Y yield will likely hit -0.50% at end-2020.

■ FX: Narrower growth and rate differentials between the US and the eurozone offer EUR-USD some upside potential.

We expect the GBP to recover but this will likely be slowed by BoE easing and the risk of a Brexit-related “cliff edge”

in December 2020.

■ Equities: We anticipate strong corrections of up to 20% in global equities in 1H20, with some relief by year-end. 2020

will be dominated by low earnings growth in Europe and slowing earnings growth in the US. We think present

consensus estimates are too high.

■ Credit: The late-stage credit cycle warrants defensive positioning in European IG and HY credit, with a preference for

non-cyclical sectors. Technical factors such as the CSPP should support credit, though this will likely be balanced by

a deterioration in credit fundamentals and the gap to valuations will widen further.

■ CEEMEA: EM hard-currency credit is set to post a good, mostly carry-related performance in 2020 of more than 5%.

Our preference remains BBB and BB rated credit.

Link to webcast Link to presentation

Editors: Marco Valli, Head of Macro Research, Chief European Economist (UniCredit Bank, Milan) Elia Lattuga, Deputy Head of Strategy Research (UniCredit Bank, London) Chiara Silvestre, Economist (UniCredit Bank, Milan)

“

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https://webcast.meetyoo.de/index.html?e=1Nv2aDFtFIQ2

https://www.research.unicredit.eu/DocsKey/economics_docs_2019_175295.ashx?M=D&R=74770732

November 2019 Macro & Strategy Research

Macro & Markets Outlook

UniCredit Research page 2 See last pages for disclaimer.

Contents

3 Executive Summary

4 Global Macro Outlook: Late-cycle blues

9 Scenario Analysis US car tariffs and their impact on the German economy Impact on the eurozone economy if the US avoids a recession Impact of a China hard landing on world and eurozone growth

13 US: A mild recession in 2H20, slightly delayed

18 Eurozone: Domestic resilience set to fade 23 Germany 25 France 27 Italy 30 Spain 32 Austria

33 CEE: Outlook shaped by external risks

38 United Kingdom: Persistent Brexit uncertainties, sluggish growth

40 Sweden & Norway: Tightening cycle likely to have run its course

41 Switzerland: Growth slowing but SNB steady

42 China: Trade uncertainty to weigh on growth

43 Oil: Brent prices to remain weak

44 Cross Asset Strategy: Prefer fixed income as a US recession nears

47 FI Strategy UST yields to decline on Fed’s action and growth slowdown Bunds: no respite from negative yields Portfolio recommendation: overweigh duration in USTs, be more cautious with Bunds Risk symmetry skewed towards higher Bund yields whereas it is more balanced for USTs

56 FX Strategy: The absence of major FX trends is likely to continue

61 Equity Strategy: Downside risks to prevail, particularly in 1H20

65 Credit Strategy Investment grade: cashing in carry in a prolonged late cycle High yield: marked spread widening expected amid economic slowdown

70 CEEMEA Strategy: Solid performance amid hunt for yield

72 Table 1: Annual macroeconomics forecasts 73 Table 2: Quarterly GDP and CPI forecasts 73 Table 3: Oil forecasts 74 Table 4: Comparison of annual GDP and CPI forecasts 75 Table 5: FI forecasts 76 Table 6: FX forecasts 77 Table 7: Risky assets forecasts

Editorial deadline: 20 November 2019, 18:00 CET




Executive Summary Erik F. Nielsen Group Chief Economist Global Head of CIB Research (UniCredit Bank, London) +44 207 826-1765 [email protected]

■ We expect the global economic slowdown to continue for another year as the weakness in

manufacturing spreads to services and consumers, broadly following the normal pattern for

this late stage of the business cycle. We forecast a trough in global growth in the second

half of 2020, followed by a gradual recovery in 2021 – although back towards a lower

trend-growth rate than in the past, primarily because of the rolling back of globalization.

■ We think the US will experience a mild recession in 2H20 while European growth will

bottom out during the same period at low but positive growth rates, with the weakness

concentrated in some countries, including Germany, Italy and Russia. By the end of 2021, we

expect US GDP growth to be back towards 2%, eurozone growth towards 1.5% and the CEE

region at close to double that (all annualized rates). If we are broadly right on this predicted

path, we will see both US and eurozone annual growth at close to 1% in 2020 and 2021,

and about double that in CEE, but with substantial changes over this two-year period.

■ The risks to the outlook seem higher than usual, and they are all man-made. The single

biggest source of uncertainty is trade policy and its impact on sentiment and, hence, on

investment, with important long-term consequences for global value chains and trend

growth. We have assumed a standstill, roughly speaking, in the present trade war, which

has already done substantial damage to growth. We acknowledge the two-way nature of

the risk, although the downside risk seems more prevalent. There is a risk of escalation if

US President Donald Trump starts to look for external scapegoats to blame for the slowing

US economy, as well as the possibility of some roll-back as a way of "declaring victory" in

his highly publicized trade policy.

■ Brexit poses another material risk, primarily to the UK itself but also to the rest of Europe.

The actual timing of Brexit remains unknown (with even a non-negligible probability of it

never happening), but more importantly, Brexit will be followed by a transition period of

great uncertainty about what trade agreements the UK will have with continental Europe,

the US and China – if any.

■ Monetary policy across most of the world is set to ease as the downturn proceeds. We

expect the Fed to cut rates by a total of 100bp, but both the call and the effect are

uncertain, not least since most other major central banks are likely to ease policy –

although not the ECB, which seems to have entered a period of virtual paralysis. This

could have an impact on exchange rates. We expect EUR-USD to move higher, to 1.16 by

the end of 2020.

■ There is also uncertainty with respect to fiscal policy, with much debate about possible

easing in both the US and Europe, but we are not convinced. In the US, the split Congress

is likely to prevent any meaningful policy changes, at least until after the elections, and in

Europe the overwhelming view among the fiscal authorities in those countries with fiscal

room remains one of no urgency.

■ Given this outlook, and present valuations, we recommend a shift towards safer assets.

We expect weak equity markets, with corrections of up to 20%. UST yields seem likely to

fall throughout 2020, ending the year at around 1.0% for the 2Y and 1.5% for the 10Y. An

unchanged ECB stance will likely keep the 2Y German yield around present levels, while

the 10Y Bund yield should move to about -0.5% by the end of 2020. We expect BTPs to be

caught again between search for carry and domestic politics. We see the 10Y BTP/Bund

spread ending the year at 150bp.




Global Macro Outlook

Late-cycle blues

Dan Bucsa Chief CEE Economist (UniCredit Bank, London) +44 207 826-7954 [email protected]

Dr. Andreas Rees Chief German Economist (UniCredit Bank, Frankfurt) +49 69 2717-2074 [email protected]

Daniel Vernazza, PhD Chief International Economist (UniCredit Bank, London) +44 207 826-7805 [email protected]

■ Global real GDP growth is set to weaken further from 3.0% in 2019 to 2.7% in 2020 as the

US economy enters a downturn and protectionist tensions are unlikely to fade. The Fed will

probably cut rates by 100bp next year, while we expect the ECB to stand pat and focus on

its policy review. The CEE region will likely slow as a result of external headwinds. Global

growth will likely recover modestly to 3.2% in 2021.

■ The risks to the global outlook remain tilted to the downside. Most importantly, trade

tensions could escalate, leading to lower global trade, sentiment, and investment, and a

tightening of broad financial conditions. The risk of a hard Brexit at the end of 2020

remains, as does the risk of a hard landing in China.

1. Baseline forecasts

Our global GDP and trade forecasts

We expect global GDP growth to slow from 3.0% in 2019 to 2.7% in 2020 before recovering to

a still-modest 3.2% in 2021 (Chart 1). Global trade is likely to remain sluggish: we forecast

meager rises of 0.6% in 2020 and 0.9% in 2021 (2019: -0.4%) compared to a long-term

average annual increase of around 4%. Signs of increasing momentum in global trade are not

likely to emerge before 2021.

Regional and country forecasts We expect the US economy to enter a mild recession in the second half of 2020, driven by

declining corporate profitability and ongoing trade tensions. The weaker global backdrop is

likely to cause the eurozone to slow a little further next year. The Fed will probably cut rates

by 100bp in 2020, while we expect the ECB to stand pat and focus on reviewing its policy. In

emerging markets (EM), the expected cyclical downturn in global trade, commodity prices and

capital flows will likely keep economic growth below potential by tightening financial

conditions. China is expected to slow modestly as the fiscal and monetary stimulus cushions,

but does not arrest, the structural and cyclical slowdown. Several large emerging markets that

experienced contractions in output this year, including Argentina, Brazil, Mexico, South Africa

and Turkey, will probably recover only modestly next year due to persistent structural issues.

The CEE region is set to slow next year as a result of external headwinds.

CHART 1: GLOBAL GROWTH SET TO SLOW FURTHER IN 2020 CHART 2: US SHORT- AND LONG-RUN REAL RATES

Source: Bloomberg, IMF, UniCredit Research

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21

Global real GDP growth, % yoy

2001-2018 average

Forecasts

-0.8

-0.4

0

0.4

0.8

1.2

1.6

Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 Jul-19

US real 5Y5Y bond yield (%) US real 2Y1Y bond yield (%)

mailto:[email protected]






2. Key judgements

We have made four key judgments that are critical for our outlook: ongoing trade tensions, the

US entering a mild recession in 2H20, and a limited monetary and fiscal policy response.

Key judgement 1: trade tensions and heightened macro uncertainty are here to stay

We expect trade tensions to continue in the medium term, although without escalating further.

While the US and China are reportedly close to signing a “Phase one” agreement, it appears

tentative and partial. It involves the US delaying or cancelling planned tariff increases (and

possibly some rollback of tariffs in stages), in return for China agreeing to purchase

significantly higher amounts of US agricultural produce. Importantly, however, such an

agreement would not deal with any of the underlying issues in the dispute. Notably, the US

has become markedly skeptical towards the benefits of globalization, if not outright

protectionist, and the issue extends well-beyond US President Donald Trump. Furthermore,

China’s forced technology transfer and subsidies to state-owned enterprises are issues that

both seem insurmountable over the forecast period. Therefore, these trade tensions are likely

to persist. Our base case assumes no escalation but also no large-scale (or significant)

rollback of previous tariffs. The threat of escalation will remain. We do not expect the US to

impose tariffs on cars, which would mostly impact the EU, but the threat will likely remain.

Brexit-related uncertainties are likely to persist over the forecast period, whether the

Conservative Party wins a majority (as seems likely) or not. Geopolitical risks are likely to

remain elevated. Poor economic performance could reinforce political risks in EM, with Latin

America prominent.

Key judgement 2: US enters a mild recession

The US economy is set to slow below potential in the coming quarters and enter a mild

technical recession in 2H20. Our recession probability model signals a high likelihood of a

recession within the next 12 months. Typical late-cycle effects are visible in declining

corporate profit margins, and debt vulnerabilities have increased among US firms. The Fed

has said it will not cut rates again until growth has weakened materially, by which time it may

well be too late.

Key judgement 3: only moderate impulses from monetary policy

Global monetary policy has been loosened, most notably in the US. This easing has been in

response to weaker global growth and significant downside risks. To the extent that the fall in

short-term rates reflects a reduction in the equilibrium rate of interest due to heightened

uncertainty, the stimulus embodied in lower rates is likely to be limited. Indeed, the US 2Y1Y

forward real yield – a useful indicator of the real policy rate at the monetary policy horizon –

has fallen almost in lockstep with the 5Y5Y forward real yield – a gauge of the equilibrium real

rate that is neither stimulative nor restrictive (Chart 2). Indices of broad financial conditions

are only modestly looser compared to where they were a year ago; that is, before the Fed

initiated its shift away from a tightening bias. In most advanced economies, particularly in

Japan and the eurozone, there is much less monetary policy space than there has been

during previous easing cycles. In China, the required deposit reserve ratio (for major banks)

has already been cut from 17% in spring 2018 to 13% and the PBoC has scope for significant

further loosening, although the authorities are wary of inflating a credit bubble.

Key judgement 4: limited help from fiscal policy

Only moderate impetus can be expected from global fiscal policy. In the US, a split Congress

is unlikely to deliver any significant stimulus, especially in light of the pending presidential

election in 2020. In the eurozone, policymakers are either not willing or not in a position to

accelerate spending. In a majority of member states, elevated public indebtedness has put

tight constraints on fiscal policy. In Germany, there are both political and legal arguments for

limiting fiscal expansion, despite significant surpluses in the public budget. Only in China, is a

moderate growth initiative already in the pipeline. Apart from a cut in the VAT rate in spring

2019, credit volumes have been increasing again (Chart 3). But this is likely to do no more

than cushion the structural slowdown in China and the high indebtedness of Chinese

companies makes a significant increase in leverage unlikely. Large budget deficits in many

EM may not allow for increased government spending (Chart 4).




CHART 3: CHINESE CREDIT IMPULSE GETTING STRONGER CHART 4: LARGE EM HAVE LITTLE FISCAL SPACE LEFT

Source: Bloomberg, Eurostat, IMF, national statistical offices, NBS, UniCredit Research

3. Current economic conditions

Slowest global growth since 2009

The global economy has slowed throughout 2019 and, at 2.9% annualized in 3Q19, is now

expanding at its weakest pace since 2009. The slowdown likely originated from global trade

tensions (notably US-China trade talks and Brexit negotiations) and associated heightened

macro uncertainty, as well as the impact of the past tightening of financial conditions

(particularly in the US), and domestic weakness in some major emerging markets (Argentina,

Brazil, Mexico, South Africa and Turkey).

Subdued business confidence Business confidence has fallen globally amid heightened trade-policy uncertainty and

geopolitical tensions. This is especially true for the export-dependent manufacturing industry.

The global manufacturing PMI declined further until summer 2019, when some stabilization

set in (Chart 5). In contrast, consumer confidence has so far been relatively resilient, as labor

markets remain solid.

Weak manufacturing, trade, and investment

The fall in business confidence has led to investment being either deferred or cancelled.

Capital goods orders – an indicator of business investment – has been in decline in the US

and the eurozone (Chart 6). Investment goods have the highest imported content, and this

has exacerbated the weakness in global trade, which entered a technical recession in 2Q19.

For many advanced economies, the more export-oriented manufacturing sector has been in

recession for some time.

CHART 5: GLOBAL PMIS SHOW SIGNS OF STABILIZING CHART 6: CAPITAL GOODS ORDERS HAVE TURNED DOWN

Source: IHS Markit, BEA, BLS, ECB, European Commission, OECD, UniCredit Research

48

50

52

54

56

58

-20

-10

0

10

20

30

Sep-09 Sep-11 Sep-13 Sep-15 Sep-17 Sep-19

China credit impulse (% of GDP, advanced 9M)

Global manufacturing PMI (rs)

BG

CZ

HR

HUPL

RO

RSRU

SKTR

UAMXBR

CL

SA

IDIN

CN

AG

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

-8.0 -6.0 -4.0 -2.0 0.0 2.0 4.0

Prim

ary

ba

lan

ce

(%

of

GD

P)

Budget balance (% of GDP)

-1.2

-0.8

-0.4

0.0

0.4

0.8

1.2

Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Jan-19

Services Manufacturing Manufacturing new export orders

Global PMI, differences from averages since 2000 in number of standard deviations

93

94

95

96

97

98

99

100

101

102

-40

-30

-20

-10

0

10

20

Sep-01 Sep-04 Sep-07 Sep-10 Sep-13 Sep-16 Sep-19

Capital goods orders in US and EA OECD business confidence (rs)

% yoy, 3M MA Index




Resilient services and consumption

In contrast, private consumption and services activity has been relatively resilient and has

typically been the main – or in some cases only – driver of GDP growth. Unemployment is

historically low, tight labor markets have pushed up wage growth and price pressure remains

low, which has driven real household income growth. This largely explains the relative

resilience of consumer confidence, but the savings rate has gradually increased in the

eurozone, the US, and the UK, perhaps reflecting increased precautionary saving in response

to heightened uncertainty.

Spillover into domestic services and labor markets

There are some early signs that the weakness in manufacturing, trade and investment is

spilling over into domestic services and labor markets. It is true that the global services PMI

has remained slightly above the 50 level that marks no-change recently, and above the global

manufacturing PMI. However, relative to its historical average, the services PMI is now

weaker than the manufacturing PMI (Chart 5). Furthermore, labor markets are cooling off.

This is probably clearest in Germany, the UK and the US. Job openings – a leading indicator

of employment – have been falling in all three regions (Chart 7).

Leading indicators are subdued

The negative spillover effects from the export-dependent manufacturing sector into the

services sector are likely to continue. This is the message from recent leading indicators,

which paint a picture of subdued activity in global trade in the short-term. The OECD and the

Bundesbank leading indicators have continued to decline, albeit less markedly than at the

start of 2019 (Chart 8). Our proprietary leading indicator, which reflects short-term fluctuations

in global trade (on a 3M-3M basis) trod water in October. The latest signal is consistent with

global trade rising by a meager 1% on an annualized basis at the end of 2019.

Emerging markets A combination of poor global trade, lower commodity prices and volatile capital flows has

affected emerging markets (EM) in 2019. Several large EM countries were in recession at the

same time, including Argentina, Brazil, Mexico, South Africa and Turkey, although most of

them have now exited recession or are expected to do so soon. China’s economy continued

to slow due to structural forces and trade tensions with the US. Southeast Asia excluding

China, the EM outperformer in 2H19, benefitted from the Chinese credit impulse but lower

Chinese growth will likely eventually weigh on this region’s growth rates.

CHART 7: JOB OPENINGS HAVE EASED IN SOME COUNTRIES CHART 8: LEADING INDICATORS STILL SOMEWHAT DECLINING

Source: BLS, Bundesbank, Eurostat, OECD, ONS, UniCredit Research

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 Jan-19

US Germany UK

Job openings to employment ratio (six-month change in ratio, in pp.)

93

94

95

96

97

98

99

100

101

102

103

200

3

200

4

200

5

200

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

201

4

201

5

201

6

201

7

201

8

201

9

Bundesbank OECD

Indices




4. The risks

1. Escalating trade tensions The most important risk to our global growth forecasts is an escalation of trade tensions. The

US and China have already threatened further tariff hikes if no “Phase one” agreement is

reached. In this scenario, business confidence, especially among exporters worldwide, could

take a hit and rein in global investment spending even further. Export-dependent countries

such as Germany would probably fall into deep recessionary territory, thereby putting

downward pressure on the eurozone economy as a whole. Supply chains between the US

and China and, to some extent, globally could also be distorted. The EU seems to be

comparatively shielded from such adverse effects. Nearly two-thirds of the EU’s global value

chains are within the EU. Besides effects on global trade, turbulence on FX and bond markets

could amplify the negative impact on the global economy. Given that China imports much less

from the US than the US imports from China, other retaliatory tools may be considered by

Chinese policymakers. In August 2019, the US officially labeled China a currency

manipulator. China responded by temporarily depreciating the CNY against the USD. Another

possibility is that China may decide to continue selling some of its holdings of US treasuries,

which currently amount to around USD 1,100bn, which could result in a sharp rise in medium

to longer-term interest rates. Finally, China might introduce curbs on rare-earth exports that

are key for the tech sector.

US President Donald Trump could raise US auto tariffs. His decision is still pending and the

administration could always trigger a new investigation under the 1962 Trade Expansion Act.

The impact of such tariff hikes would fall disproportionately on the EU and, in particular,

Germany (see Scenario Analysis section on US car tariffs and their impact on the German

economy).

The probability of a no-deal Brexit before the end of 2020 is approximately zero now that Prime

Minister Boris Johnson has agreed a revised Brexit deal with the EU and is campaigning for his

deal ahead of the 12 December general election. However, if Mr. Johnson’s Conservative Party

wins a majority of seats, as we expect, then the risk of a no-deal Brexit at the end of 2020, when

the standstill transition period would end, is very real indeed.

2. Hard landing in China China is trying to rebalance its economy away from exports and overinvestment and towards

consumption. History shows this transition is unlikely to be smooth. Moreover, China’s

corporate sector has amassed huge corporate debt, and now that the economy is slowing

amid trade tensions with the US and slower global growth, the Chinese authorities are

stimulating credit again. Such large increases in credit-to-GDP typically do not end well, often

culminating in a financial crisis or several years of much weaker growth. There is also a risk

that the policy stimulus does not work (see Scenario Analysis on the Impact of a China hard

landing on world and eurozone growth).

3. US avoids a recession In our baseline forecast, we expect the US economy to slow further and enter a mild

recession in 2020. A positive risk scenario is that, instead, the US expands broadly in line with

its potential over the forecast period. This could materialize if pre-emptive Fed easing is more

stimulative than we expect, the US consumer remains resilient against our expectations, and

there is more spare capacity in the labor market than most estimates suggest (see Scenario

Analysis on Impact on the eurozone economy if the US avoids a recession).




Scenario Analysis

US car tariffs and their impact on the German economy


Dr. Thomas Strobel Economist (UniCredit Bank, Munich) +49 89 378-13013 [email protected]

Germany’s car exports to the US are significant… …however, in terms of global value chains, Germany’s exposure becomes smaller

US tariff shock depends on various factors, such as export exposure, pricing behavior…

US President Donald Trump’s decision on raising US auto tariffs is still pending.1 The US has

already reached trade agreements with several major auto-exporting countries such as

Mexico, Canada, Japan and South Korea.2 Hence, the risk of higher tariffs largely affects the

EU, and Germany in particular.

Back in March 2018, Mr. Trump threatened to raise auto tariffs on cars from 2.5% to 25%, in

line with the 25% tariff on light trucks (pickups). The EU currently charges 10% tariffs on both

cars and light trucks from the US . In our scenario analysis, we assume a US tariff increase to

25% on cars and car parts and examine its effects on the German economy.

The US export share of the German auto industry is significant, amounting to 13% (EU: 51%;

China: 10%). This represents roughly 1½% of German exports in goods and services and

0.7% of GDP. Compared to other countries, German carmakers rank fourth in terms of gross

exports to the US (USD 28bn) after Canada (USD 54bn), Mexico (USD 52bn) and Japan

(USD 49bn). However, the rise of global value chains makes Germany’s actual exposure

smaller. About a third of the value of German gross auto exports to the US can be attributed

to other countries, in particular the EU-15 (USD 5bn) and the newer EU member states in

CEE (USD 1bn).3 The tariff shock would therefore not only have a direct negative impact on

Germany but also an indirect effect on other EU countries.

The quantification of a US tariff shock on domestic activity not only depends on Germany’s

(value-added) export exposure. Assumptions on German carmakers’ pricing behavior and

how US consumers are likely to respond also have to be made. Since there is a wide range of

possibilities, substantial uncertainty exists. For instance, carmakers could try to pass on

higher tariffs to US consumers or they may leave auto prices unchanged by accepting

reduced profit margins from their US business. The latter could possibly be offset by stronger

demand for cars in other countries, i.e. the decision could also depend on the outlook outside

the US. If prices of German cars increase, US consumers may still continue to buy them due

to quality, branding, etc. Alternatively, given high price elasticity of imports, US consumer

demand could increase for domestically produced or Asian cars.

US TARIFF HIKE STILL A RISK IN 2020 ONE THIRD OF GERMAN AUTO EXPORTS PRODUCED ABROAD

Source: WTO, IMF, UniCredit Research

1 According to some legal experts, by missing the deadline in mid-November, Mr. Trump has forfeited his authority to impose higher car tariffs on basis of the Trade

Expansion Act of 1962. However, the US administration may still find other legal means to demand higher auto tariffs. 2 In its agreement with Japan, customs duties on autos are subject to further negotiation.

3 Huidrom, R. et al., Trade Tensions, Global Value Chains, and Spillovers, Insights for Europe, IMF Working Paper, June 2019

0

5

10

15

20

25

30

Cars Light trucks

US tariffs EU tariffs

In %

0

10

20

30

40

50

60

CAN MEX JPN DEU KOR UK ITA

Foreign Value Domestic value

Auto exports to the US, in USD bn (2017)






…and import elasticities

Second-round effects include the impact on R&D and business sentiment

Overall, US tariffs are likely to shave-off 0.3-0.5% of German GDP

Estimates of the import elasticity in the economic literature confirm this wide margin of

uncertainty. They range from 0 to 0.15, i.e. from a completely inelastic demand to a decline of

0.15% in demand in response to a tariff hike of 1pp. In a recent analysis, the IMF assumed

the midpoint of this range for the import elasticity (0.08) and a US tariff of 25% imposed on

cars and car parts. Using value-added exports, the impact is estimated to be 0.15% of

German GDP.4 The IMF estimate takes into account not only the direct impact of lower

demand on the German auto industry, but also the effects on domestic suppliers in other

sectors. Examples are the chemical industry, machinery and metals. When gross exports are

applied, the estimated GDP loss is roughly 0.2%. With a substantially higher import elasticity

of 0.15, the estimated negative GDP effect would double (0.3-0.4%).

Besides this first-round impact due to lower export activity, second-round effects are possible.

The negative economic impact could multiply by triggering additional negative responses of

companies and consumers. In the event of a tariff shock, we consider the following two

transmission channels to be particularly important. Lower research and development

expenditure (R&D) by the German auto industry and a hit to overall German business

sentiment caused by rising uncertainty.

The car industry spends far more money on R&D than any other sector. In 2017, the figure

was about EUR 25bn, or more than a third of total R&D (0.8% of GDP). A US tariff shock

could lead to cuts in R&D expenditure and, hence, in investment activity. The decision to cut

R&D may also depend on the general outlook for the auto industry. The more pessimistic

business expectations are, the more likely such a scenario is.

Another major transmission channel for second-round effects is overall business confidence.

Uncertainty about the impact of a tariff hike on the German economy could lead to a broad-

based and at least temporary decline in business sentiment. Companies in other sectors that

are not actually related to the car industry may decide to play it safe and forgo further capex

spending and hiring. As a result, negative multiplier effects would kick in and put an additional

strain on economic activity.

Uncertainty about the second-round effects is also high. We estimate that another negative

GDP effect of 0.1-0.3% may materialize. Taken together, the GDP loss resulting from the US

hiking tariffs to 25% could amount to 0.3-0.5% in the first year after implementation.

Afterwards, the negative effect will likely start to fizzle out.

HIGH R&D EXPENDITURE OF GERMAN CAR SECTOR FIRST SIGNS OF BOTTOMING OUT IN CAR SECTOR

Source: OECD, Ifo, UniCredit Research

4 Huidrom, R. et al., Trade Tensions, Global Value Chains, and Spillovers, Insights for Europe, IMF Working Paper, June 2019

0

5

10

15

20

25

30

Auto Services Machinery Pharma Chemical ICT

In EUR bn (2017)

-80.0

-60.0

-40.0

-20.0

0.0

20.0

40.0

60.0

1992

199

3

199

4

1995

199

6

199

7

1998

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9

Business expectations Inventory assessment

Ifo survey (balances), 3-month moving average




Impact on the eurozone economy if the US avoids a recession

Marco Valli Head of Macro Research Chief European Economist (UniCredit Bank, Milan) +39 02 8862-0537 [email protected] Daniel Vernazza, PhD Chief International Economist (UniCredit Bank, London) +44 207 826-7805 [email protected]

In our baseline forecast, we expect the US economy to slow further and enter a mild recession

in 2020 (see United States macro section), which is an out-of-consensus call. We provide an

indication of how sensitive our eurozone GDP growth forecasts are to this key judgement and,

hence, what one might reasonably expect if the US manages to avoid a recession.

Specifically, in this positive risk scenario, we assume that the US economy expands broadly

in line with potential in 2020 (1.8%) and slightly below it in 2021 (1.5%). Compared to our

baseline scenario, this would imply a positive growth shock amounting to a cumulative 1.3pp

over the next two years.

How the US could avoid a recession

We identify three main reasons why such a scenario could materialize: 1. The Fed has moved

preemptively. Its U-turn on monetary policy one year ago has lowered the 10Y UST yield by

around 130bp. Lower mortgage rates have seen the US housing market pick up. And the

transmission to the real economy is still ongoing. In the late 1990s, a similar level of monetary

easing was enough to delay the onset of a recession by a few years; 2. While the US labor

market is running hot by most estimates of the US equilibrium unemployment rate, wage

growth is not exactly running away, which might suggest that the equilibrium unemployment

rate is lower than previously thought. This would reduce the need for a correction in the labor

market. 3. Consumption has been resilient, and while it is rare for an economy to run on a

single growth engine for a sustained period, it is possible that US consumers look through

heightened macro uncertainty and continue spending while investment stays weak. In

particular, the fiscal stimulus could fade later than we expect.

Transmission channels

The transmission of firmer US growth to the eurozone would materialize mainly via three

channels: trade, financial conditions and oil prices.

The US is the eurozone’s largest trading partner

The trade effects are both direct and indirect. The former are related to effects only channeled

through bilateral trade linkages between the US and the eurozone. As a reference, the US is

the eurozone’s largest trading partner, accounting for more than 14% of total (extra-euro-

area) merchandise exports. This compares with 12.1% for the UK and 7.4% for China.

Indirect trade effects amplify the transmission of the US shock through the response of

exports and imports in third markets.

Broad financial conditions would likely improve

The impact through financial conditions and market sentiment is the most difficult to predict,

because to a large extent it depends on how the major central banks (starting with the Fed)

react to the stronger growth outlook. Other conditions being equal, resilient growth in the US

would lower the cost of capital, reduce volatility and compress credit spreads. However, the

response of financial markets might become more blurred when a (countercyclical) monetary

policy stance is taken into account. In our simulation, we assume that the net impact on

financial conditions is positive, thus contributing to strengthening the impulse from trade.

Oil prices unlikely to move materially higher

The response of oil prices is likely to be more contained than in the past. This is due to the

more competitive structure of the oil market after the shale revolution in the US, and it seems

likely that OPEC+ could see a weakening of incentives to cap supply if and when oil demand

starts to recover. This would mitigate the upward pressure on oil prices in this positive

scenario – good news for the eurozone, which is a net energy importer.

Eurozone growth could be 0.6-0.7pp higher

Overall, we estimate that a positive shock to US GDP of 1pp could lift eurozone GDP growth

by about 0.5pp. Therefore, in our simulation, eurozone growth could be boosted by a

cumulative 0.6-0.7pp (and core inflation by 0.1-0.2pp). In terms of timing, positive US shocks

tend to be transmitted more slowly to the euro area (and the rest of the world) than

downturns. This implies that some of the boost to eurozone growth would probably materialize

outside our two-year forecasting horizon.






Impact of a China hard landing on world and eurozone growth

Edoardo Campanella Economist (UniCredit Bank, Milan) +39 02 8862-0522 [email protected]

Our baseline scenario assumes a smooth deceleration in the growth of the Chinese economy

(see China macro section) throughout the forecasting horizon, down to 5.7% in 2021 from

current 6.2%. However, a number of factors pose a risk that the loss of momentum could be

harsher and China might face a hard landing.

We assume a large shock to China’s domestic demand

The most prominent risk is an escalation in the US-China trade war. An alternative trigger,

which we explore here, is a severe slowdown in domestic demand. We assume that

traditional monetary and fiscal stimulus proves ineffective in supporting the domestic drivers

of growth at a time when marginal returns of policy action are declining and financial stability

concerns might prevent Beijing from adopting alternative measures. The resulting shock to

domestic demand leads to a meaningful slowdown in China’s GDP growth, from 6.2% in 2019

to 3% in 2021. This implies a GDP loss of about 3pp compared to our baseline and the shock

propagates to the rest of the world through both trade and financial channels.

Transmission channels The main transmission channels are trade (both directly and indirectly through third countries)

and financial markets. Trade links are fairly strong. China is the third most important

destination for euro area exports outside of the eurozone (accounting for around 7% of the

total), after the US and the UK. Only about 70% of these exports are consumed domestically

in China (the remaining 30% are used as intermediate goods within global value chains that

are centered around the Chinese economy). Thus a drop in China’s domestic demand would

not be fully passed on through eurozone exports.

China’s direct financial ties with the eurozone are relatively limited, partly due to remaining

restrictions on cross-border financial transactions, investment and banking activities in China.

However, the shock is likely to meaningfully impact sentiment in financial markets, leading to

a tightening of financial conditions.

Impact on global and eurozone GDP growth

To quantify the impact of such a scenario on eurozone and world GDP growth, we use

elasticities estimated by the OECD.5 When both trade and financial links are considered, a

1pp slowdown in Chinese GDP growth driven by domestic demand is likely to reduce

eurozone GDP growth by -0.25pp and world GDP growth by -0.4pp. In 2021, eurozone GDP

would be roughly 1% lower than that outlined in our baseline scenario, while world GDP would

be 1.5% lower.

CHINA’S HIGH LEVERAGE POSES RISKS ASSESSING THE GROWTH SPILLOVERS

Source: Bank for International Settlements, UniCredit Research

5 See OECD, “Interim Economic Outlook”, September 2015.

0

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Credit to NFCs (% GDP)

China Thailand Japan United States Spain

Asset price bubble

Asian crisisSubprime crisis

Housing bubble

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EMU World

Deviation from baseline GDP level (trade + financial links, %)





US

A mild recession in 2H20, slightly delayed


■ We expect US real GDP growth of 2.3% in 2019, 1.1% in 2020 and 0.9% in 2021.

The economy will likely enter a mild technical recession in 2H20.

■ The Fed is likely to resume rate cuts in 1Q20, cutting 25bp per quarter until end-2020, as

economic activity comes in weaker than the central bank expects.

A slowdown is already in train The US economy is slowing. Real GDP expanded 1.9% annualized in 3Q19, down from a

quarterly average of 2.6% in 1H19, 2.5% in 2018 and 2.8% in 2017. Payroll gains have

eased: the monthly change in private payrolls averaged 152,000 year-to-date, down from

215,000 in 2018. Following a series of weaker data recently, the Atlanta Fed’s latest estimate

of 4Q19 GDP growth has fallen to just 0.4% annualized; however, we expect a more modest

growth deceleration to 1.6% annualized.

Running on a single growth engine

The composition of GDP growth reveals that growth is now entirely dependent on personal

consumption and, to a lesser extent, public consumption (Chart 1). Fixed investment growth

has been negative for the last two consecutive quarters. A widely used proxy for business

investment intentions, non-defense capital goods orders excluding aircraft, has been falling in

real terms for 9 out of the last 11 months on a 3M/3M basis6. US trade tensions and

associated heightened macro uncertainty is weighing on business confidence, leading firms to

defer or cancel investment decisions. The more export-oriented manufacturing sector entered

a technical recession in 2Q19 and 3M/3M growth remained negative in October (Chart 2).

History suggests that consumption and services, on the one hand, and investment, exports

and manufacturing, on the other, will not be able to decouple for a sustained period.

The fiscal stimulus will fade The Trump administration’s fiscal stimulus has been responsible for pushing real GDP growth

above its long-run potential (around 1.8%) in 2018 and 2019. The Hutchins Center Fiscal

Impact Measure estimates the total impact of the fiscal stimulus – both the direct effects of

federal and local government spending and the indirect effects of government taxes and

transfers on private consumption – and calculates that it contributed a substantial 0.6pp to

average quarterly annualized GDP growth in the first three quarters of 2019. In contrast, it

expects the fiscal impact to be negligible in 1Q20 and then negative from 2Q20 through 3Q21.

Importantly then, the fiscal stimulus is expected to turn into a net drag on growth next year.

CHART 1: RUNNING ON A SINGLE GROWTH ENGINE CHART 2: MANUFACTURING ACTIVITY IS WEAK

Source: BEA, Federal Reserve, ISM, UniCredit Research

6To deflate nominal capital goods orders, we use the US PPI for final demand of private capital equipment.

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* 1Q19-3Q19 average 30

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The labor market is showing signs of turning

Consumption has also been resilient because of solid personal real income growth (reflecting

still-strong payroll gains, decent wage growth and a muted PCE deflator) and relatively high

consumer confidence (in part driven by a wealth effect from high stock prices). While monthly

payroll gains have eased, so far they have still been sufficient to prevent the unemployment

rate from rising. A robust consumer is also evident in the pick-up in the housing market since

the turn of the year, initiated by Fed monetary-policy easing that has lowered mortgage rates.

Still, there are early signs that the labor market is turning. Job openings – historically a

reliable and leading indicator of employment – have been on a declining trend since the turn

of the year and signal a more pronounced slowdown in hiring ahead (Chart 3). Average hourly

earnings growth has been subdued for the past two months, which means personal

consumption growth will likely ease in 4Q19.

CHART 3: FALL IN JOB OPENINGS POINTS TO LOWER JOB GAINS CHART 4: UNIT LABOR COSTS HAVE INCREASED

Source: BLS, UniCredit Research

Late cycle, falling margins and lower expected earnings

The current US expansion, at 125 months and counting, became the longest economic

expansion on record on 1 July 2019, beating the previous record set from March 1991 to

March 2001 when the dotcom bubble burst. While recoveries do not die of old age, and the

current expansion has been one of the slowest, we are seeing typical late-cycle effects

playing out. The unemployment rate, at 3.6%, is 1pp below the CBO’s estimate of the

equilibrium rate. It has pushed up unit labor cost growth, to 3.1% yoy in 3Q19 (Chart 4).

Firms, however, have felt unable to pass on these cost rises to consumers, and both headline

and core PCE inflation remain muted. Consequently, profit margins of non-financial

corporations continue to fall: after peaking at 22.9% in late 2014, margins fell to 17.8% in

2Q19 (Chart 5). Margins typically fall ahead of a recession.7 Analysts expect corporate

earnings to decline over the next 12 months, particularly for smaller firms that make up the

Russell 2000 index (Chart 6). As well as the weaker macro outlook, some of the decline in

expected earnings reflects negative base effects from US corporate tax cuts. Declining

profitability will weigh on investment and hiring.

High corporate debt increases vulnerabilities

Meanwhile, US corporates have increased their vulnerability to adverse shocks. Corporate debt

has risen sharply over the last few years and, at 75% of GDP, it is now higher than its previous

4Q08 peak (Chart 7). The debt-service ratio (the ratio of interest payments plus amortizations to

income) of private non-financial companies has also risen sharply due to the rise in debt, past

Fed tightening and weak corporate profits. The good news for corporates is that the Fed has

moved preemptively by cutting interest rates. But this is set against declining profitability.

7Empirically, it is the change in margins rather than the level that has predictive power for the onset of a recession. Margins have trended higher since the early 1990s,

likely reflecting secular forces including globalization and firm concentration.

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US Unit Labor Costs, non-farm business sector (advanced 3 quarters)

US Core PCE - rs% yoy % yoy




Valuations of US equities are stretched

The accumulation of corporate debt has predominantly not been used to finance productive

investment, but rather to finance payouts to shareholders, in the form of dividends and share

buybacks.8 It has boosted share prices, with the S&P 500 making new highs. Valuations of

US equities are already stretched based on current 12M forward earnings estimates. And, in

our view, consensus earnings estimates are far too high (see the Equity Strategy section).

High equity valuations are also predicated on expectations of further monetary policy easing

by the Fed, and if Fed rhetoric were to disappoint those expectations, it could act as an initial

trigger for a sell-off. A sharp fall in equity prices would tighten financial conditions and weigh

on personal consumption and corporate profitability.

CHART 5: PROFIT MARGINS OF NFCS CONTINUE TO FALL CHART 6: LOWER EARNINGS ESTIMATES FOR SMALL FIRMS

Source: BEA, Bloomberg, UniCredit Research

Ongoing US trade tensions Adverse shocks are also likely to stem from persistent trade tensions. While the US and

China are reportedly close to signing a “Phase one” trade deal, it is tentative and does not

solve the underlying issues. The reported deal would involve China pledging to buy additional

imports of US agricultural goods and, in return, the US would delay or cancel the planned

implementation of additional tariffs. It does not deal with China’s forced transfer of technology,

nor China’s subsidies to state-owned enterprises. In our view, trade tensions will persist. China

is not going to fundamentally change its approach to state-owned enterprises and treatment of

property rights because the US demands it. A comprehensive trade deal is unlikely given that it

would have to cover tricky issues like “fair playing field” rules, including human rights.

Recession-probability models are flashing red

Our US recession-probability model indicates a high 48% probability of a recession within

12 months, and 70% within two years. The model uses the unemployment rate gap (the

difference between the actual unemployment rate and its estimated equilibrium rate),

residential investment as a share of GDP, and compensation per hour as predictors of a

recession. Financial markets also appear to attach a high probability to trouble ahead, as

evident by the inverted yield curve (the spread between the 10Y and 3M US Treasury yield)

from June to September this year. The slope of the yield curve has now turned positive, in

part thanks to Fed rate cuts and, to a lesser extent, increases in the 10Y yield following

reports that the US and China are close to signing a “Phase one” trade deal. As already

mentioned, we do not think the latter will prove sustainable. The yield curve is still very flat

and the damage could already have been done – indeed, the 3M/10Y spread tends to turn

positive before an NBER-dated recession starts.

8See the IMF Global Financial Stability Report (October 2019), Chapter 2: “Global Corporate Vulnerabilities”.

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1947 1956 1965 1974 1983 1992 2001 2010 2019

US net operating surplus of NFCs, % of net value added

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Jan-19 Mar-19 May-19 Jul-19 Sep-19 Nov-19

S&P 500 Russell 2000

Earnings per Share 12M forward estimate, Index 1 Jan 2019=100




CHART 7: US CORPORATE DEBT HAS RISEN SHARPLY CHART 8: RECESSION PROBABILITY MODEL

Source: BIS, UniCredit Research

A mild recession in 2H20 Reflecting the above, we expect US real GDP growth of 2.3% in 2019, 1.1% in 2020 and

0.9% in 2021. The annual averages conceal a more pronounced slowdown in quarterly

growth rates, ending in a mild technical recession – two consecutive quarters of negative

growth – in 2H20. This is delayed by one quarter compared to our previous forecast since

personal consumption has proved more resilient than we had expected.

Inflationary pressure to ease with demand

Inflationary pressure is muted, with headline PCE inflation at 1.3% yoy and core PCE inflation

– the Fed’s preferred measure – at 1.7% yoy in September. In October, core CPI inflation

eased 0.1pp to 2.3% yoy. Historically, core CPI inflation has averaged around 0.3pp above

core PCE inflation. The recent rise in core inflation from mid-2019 reflects the impact of tariffs

on core goods inflation. Headline CPI inflation is set to rise around the turn of the year, to

2.3% yoy, due to a positive base effect from gasoline prices, and then fall precipitously to

1.2% yoy by end-2020, with lower energy prices and lower core inflation combining. Core CPI

inflation has likely peaked as aggregate demand softens, wage pressure eases, and the past

appreciation of the US dollar weighs on imported goods prices.

US politics and fiscal policy US President Donald Trump is currently facing an impeachment enquiry into whether or not

he sought help from the Ukrainian president to increase his chances of re-election at the

upcoming 3 November 2020 presidential election. The US constitution states that a president

shall be removed from office if convicted. But while the Democrat-controlled House of

Representatives will almost surely vote to impeach Mr. Trump, the chances of two-thirds of

the Republican-controlled Senate voting to convict him are approximately zero, meaning Mr.

Trump would not be removed from office. As for the 2020 presidential election, at the time of

writing it is too early and too close to call. What we know is that President Trump’s job

approval ratings have held up, but whether this will continue to be the case once the economy

turns down is doubtful. The Trump administration is unlikely to stand still once they see the

economy slowing materially – reportedly, they are already looking at tax cuts. But, unlike in

2017, the Republicans do not control the House and even if they were able to target

something the Democrats could support, say tax cuts for low earners and infrastructure

spending, it’s likely to be too little, too late. It seems unlikely that trade tensions would ease

materially if the Democratic presidential candidate were to win.

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NBER recession within 1Y within 2Y within 3Y

Probability of a US recession within 1, 2 or 3 years (%)




The Fed says it has stopped cutting rates

At its 29-30 October meeting, the FOMC cut the target range for the fed funds rate to 1.50-

1.75%, the third consecutive 25bp cut this year, but signaled that it is likely done with rate

cuts, unless there is a “material” change to the outlook. Fed Chairman Jerome Powell said,

“We believe monetary policy is in a good place. We see the current stance of policy as likely

to remain appropriate, as long as incoming information about the economy remains broadly

consistent with our outlook.” Chairman Powell also noted that trade developments “have

moved in a positive direction”, citing progress towards a “Phase one” trade deal between the

US and China and a reduced probability of a no-deal Brexit. Several FOMC members have

likened the latest rate cutting cycle to the “insurance cycles” of the late 1990s, which didn’t

end in a recession (Chart 9). In our view, however, while Fed easing has helped to delay the

onset of a (mild) recession slightly, it will not prevent it. And now that the Fed has said only a

material change to the outlook would see them cut rates again, they will only act once it

becomes clear a material slowdown is happening, by which time it will be too late.

We expect the Fed to cut four times in 2020

We expect the Fed to pause in December and then to resume rate cuts of 25bp per quarter in

2020, taking the target range to 0.50-0.75% by end-2020 (Chart 10). This reflects our forecast

for materially lower GDP growth than the Fed currently expects and for trade tensions to

persist in the medium term, which forces the Fed’s hand. In our forecast, the Fed does not

use all its policy space on rates: it will be caught between the academic evidence that it’s best

to move early and aggressively, on the one hand, and the desire to keep some powder dry

given the proximity to the ZLB on the other. We expect the Fed to be on hold in 2021 as

economic growth recovers.

Policy framework review The Fed is currently in the middle of a comprehensive review of its monetary policy framework

and tools, which Fed Chairman Jerome Powell said will likely run to the middle of next year after

commencing in February 2019. Our view is that the Fed will opt to shift towards average inflation

targeting. Some key FOMC participants seem to be in favor, and more widely there is a concern

about inflation expectations becoming de-anchored after several years of below-target inflation.

Average inflation-targeting would also have the benefit of helping to move the equilibrium

nominal interest rate higher, assuming the new average target is credible, and at times when

growth and inflation are weak. Also, average inflation targeting has the appeal of being fairly

easy for the public to understand – as opposed to its close relation “price-level targeting”.

CHART 9: PAST FED EASING CYCLES CHART 10: FED FUNDS TARGET

Start

End

Duration (months)

Rate

NBER Recession

Start End Change (pp)

6/89 9/92 40 9.75 3.00 6.75 YES

7/95 1/96 7 6.00 5.25 0.75 NO

09/98 11/98 3 5.50 4.75 0.75 NO

1/01 6/03 30 6.50 1.00 5.50 YES

9/07 12/09 28 5.25 0.25 5.00 YES

Note: Rate cut cycles are defined here as any period where the Fed cut interest rates at least three times without hiking rates. Highlighted rows are “insurance cycles” that did not coincide with a recession.

Source: Bloomberg, Federal Reserve, UniCredit Research

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Jun-20

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Jun-21

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Dec-21

FOMC members' median projection (September 2019)

UniCredit forecast

Fed funds futures (18 November 2019)




Eurozone

Domestic resilience set to fade

Marco Valli Head of Macro Research Chief European Economist (UniCredit Bank, Milan) +39 02 8862-0537 [email protected]

■ GDP growth is likely to slow further, to 0.8%, in 2020, as global trade remains in the

doldrums and spillover of external weakness on domestic demand intensifies. We expect a

moderate recovery to 1.0% in 2021.

■ Monetary policy is likely to remain unchanged, but the risk of further easing will probably

increase in 2H20. The ECB’s policy review will be a key event for financial markets.

The eurozone economy is likely to end the year on a weak note, probably expanding by 0.1-

0.2% qoq in 4Q19. This would leave average growth for the whole of 2019 at 1.2%, the

slowest pace of expansion since the recession caused by the sovereign-debt crisis. Prospects

are not favorable, and we forecast that growth will lose further traction in 2020, to 0.8%.

Resilience of the domestic drivers of growth will be tested

In our baseline scenario, we assume that weakness in global trade will intensify in 2H20 as

downward pressure on the US economy builds. This challenging external environment is

expected to increasingly test the resilience of the domestic drivers of eurozone growth. Fiscal

policy is likely to remain only mildly expansionary, while the ECB’s September package

should preserve ample monetary accommodation, but is unlikely to provide sizeable

incremental stimulus. The projected mildly upward trajectory in the trade-weighted euro

exchange rate will add to the struggle of eurozone exporters.

Sequential GDP growth is likely to be firmer in 1H20 (at an annualized pace of 1%) and

weaker in 2H20, when the eurozone economy is likely to approach stagnation. We forecast a

moderate recovery in 2021, with growth likely to accelerate to an annual average of 1.0%.

Spillover of external weakness will be key

After 2019 featured a wide gap between the performance of the manufacturing and services

sectors, the key theme for 2020 will be if, and to what extent, external weakness will spill over

more clearly to domestic drivers of eurozone growth. The main transmission channel will be

fixed investment and its impact on consumers via the labor market.

Investment has been resilient so far

So far, investment in the euro area has remained resilient despite a worsening of firms’

profitability, which has reflected slower output growth and rising unit labor costs. With firms

recording a weakening in their internal generation of funds, external sources of funding have

played a greater role in the financing of investment, as firms have taken advantage of very

loose financial conditions that are a result of ECB policies. This pattern has been mirrored in

the evolution of the financing gap of the non-financial corporate sector, which measures the

excess of firms’ internal funds over their capital expenditure. Since economic activity started

to lose momentum in 2018, the (positive) financing gap has been shrinking rapidly.

CHART 1: EUROZONE GDP FORECASTS CHART 2: INVESTMENT HAS BEEN OUTPACING PROFITS

Source: Eurostat, UniCredit Research

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Eurozone* NFCs (four-quarter-cumulated sums, value)

2Q19

* Excludes Ireland





ECB monetary policy provides an important buffer

ECB monetary policy will probably remain very accommodative and thus continue to play an

important role as a shock absorber by keeping credit spreads and banks’ lending standards

supportive. However, this is unlikely to allow for a lasting decoupling of investment from

profitability. In our baseline scenario, demand from abroad fails to pick up and company

profits remain weak, thereby increasing the likelihood that investment growth will lose traction.

Capex – especially transport investment, which has performed strongly in this recovery – will

probably shoulder most of the adjustment, while the construction sector should be more

resilient even if, in line with our forecast, no major infrastructure plans are launched in any of

the big eurozone countries. Spending on intellectual property, which appears to be on a

structurally upward trend, might act as a cushion but is unlikely to prevent a slowdown in

overall investment activity. This is likely to spill over more clearly into the labor market.

Consumers have already started to adjust

The good news is that consumers have already started to build up a precautionary buffer.

Household spending has been subdued for a number of quarters, running at an annualized

pace of about 1%, almost half the growth rate of real disposable income. This has led to a

rebound in the savings rate, indicating that households have already started to adjust to a

more uncertain environment and to prospects of slower job creation. A further increase in

precautionary savings in 2020 is possible, but this would come within a context of strong

balance sheets, which increase households’ resilience to shocks. Unless the labor market and

consumer sentiment take a turn for the worse, the downside potential for household spending

– and, probably, for the whole economy – should remain reasonably contained.

Growth forecasts by country Our forecasts by country reflect a pattern in which a weak global economy damages

comparatively more those countries with a large manufacturing base and high propensity to

export goods. Therefore, we expect that Germany (0.3% in working-day-adjusted terms) will

continue to underperform the rest of the euro area in 2020, with the domestic fiscal impulse

unlikely to be large enough to reverse this trend. France (1.0%) and Spain (1.4%) will

probably confirm growth rates that are above the eurozone average. Italy (0.2%) will keep

lagging behind its main peers.

Risks to the outlook Risks to our growth outlook for the euro area are tilted to the downside. The main adverse

scenario involves an escalation of the trade war, especially if this were to also involve higher

US tariffs on European cars (which would severely hit Germany and almost certainly trigger

retaliation). The main upside risk involves a scenario where US growth remains resilient. The

Scenario Analysis section provides more details.

Core inflation to peak soon With GDP growth set to remain below potential for most of the next two years, the window for

a reacceleration in underlying price pressure will probably close before long. We expect core

inflation to peak within the next few quarters at 1.2-1.3%, after which some stabilization and

slight easing appear likely, as the widening of the output gap feeds into price formation.

CHART 3: CAPEX GROWTH DRIVEN BY TRANSPORT SECTOR CHART 4: HOUSEHOLDS’ PRECAUTIONARY SAVINGS RISE

Source: Eurostat, UniCredit Research

1.4

1.6

1.8

2.0

2.2

4.0

4.5

5.0

5.5

6.0

1Q95 2Q01 3Q07 4Q13

Machinery/equipment

Means of transport (rs)

2Q19

Capex (% of GDP)

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

11.0

11.5

12.0

12.5

13.0

13.5

14.0

14.5

1Q99 2Q04 3Q09 4Q14

Savings rate (%)

Consumer confidence (standardized, rs)

3Q19




Headline inflation to hover around 1%

Given our expectation that oil prices will decline from current levels, and with leading

indicators pointing to weakness in food inflation at least over the next six months or so, we

forecast that average headline inflation for 2020 will settle at 1%. Its trajectory is likely to be

humped: higher at the beginning of the year and lower afterwards. We predict a tentative

reacceleration in 2021 to an average rate of 1.1%, as increases in non-core components

more than offset slight easing in core inflation. Overall, inflation is going to remain far away

from the ECB’s definition of price stability for the foreseeable future.

We expect the ECB to stand pat…

We expect ECB policy to remain unchanged throughout our two-year forecasting horizon. The

central bank’s “chained guidance”, which links the end of QE to the timing of the first interest-

rate increase, would automatically bring about more asset purchases if and when the timing of

rate normalization is delayed. This mechanism would allow the ECB to cope with reasonably

limited shocks to its baseline scenario without coming under much pressure to loosen

monetary policy further. Given also fierce opposition from part of the Governing Council (GC)

to the September package, the bar for further easing is likely to be very high in the first six

months or so of ECB President Christine Lagarde’s term.

…with the risk of further easing set to increase in 2H20

However, in 2H20, the balance of risks is likely to tilt towards further accommodation as the

US slowdown intensifies, the Fed continues to cut rates and eurozone growth comes close to

a standstill. In such an environment, any clear deterioration in inflation expectations from

already-low levels would inevitably increase pressure on the ECB. If the GC is indeed forced

to do more, a rate cut (possibly with some adjustment to tiering parameters) would probably

be its first choice, especially if financial conditions were to tighten due to appreciation of the

euro. However, with policy rates already deeply negative, any such move would be

implemented mainly, if not exclusively, for signaling purposes.

All eyes on the ECB’s policy review

In 2020, the ECB is likely to carry out a review of its monetary-policy strategy. This might be a

key event for financial markets. We expect such a discussion to address two main topics:

1. the definition of price stability (which is currently “below, but close to 2% over the medium

term”) and, probably, 2. the tools the ECB can deploy to achieve its price goal.

The exact timing and length of the review are uncertain. However, the ECB should proceed

fairly quickly. We estimate that, under the current QE framework, the ECB would be able to

carry out net asset purchases for about a year – and maybe slightly longer if the flexibility

afforded by current rules is fully exploited. Therefore, especially if the ECB plans to shed some

light on its policy tools, the review would need to start within the first months of 2020 and be

wrapped up well before the end of the year due to approaching QE limits and the risk that a

material shock might force the GC to use some of its residual fire power earlier than expected.

CHART 5: PERSISTENT WEAKNESS IN INFLATION CHART 6: MARKETS DO NOT EXPECT INFLATION TO RECOVER

Source: Bloomberg, Eurostat, UniCredit Research

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Sep-14 Jul-16 May-18 Mar-20

Headline HICP (yoy %)

Core HICP (yoy %)

Forecast

Dec-211.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

3.0

Apr-04 Jun-07 Aug-10 Oct-13 Dec-16 Nov-19

5Y5Y inflation swap (%)




Price stability: It seems reasonable that the policy review will want to dispel ambiguity

surrounding the ECB’s inflation goal. If so, discussion around a new definition of price stability

might focus on two lines of thinking that would have very different implications for markets.

Possible tweaks to the definition of price stability

The first option, which we regard as more likely, could consist of adopting a symmetric

inflation goal at or just below 2%, while the second option could be a 1.5-2.5% inflation range.

Implications of the former would be neutral to somewhat dovish: the ECB would either confirm

or slightly increase its current price objective. However, implications of the latter would be

hawkish because markets would likely regard the low end of the range as the new target in an

environment of persistently low price pressure. Hence, the main message would be that the

ECB has decided to throw in the towel. In our view, this would be troublesome, especially at a

time when the Fed’s policy review is likely to strengthen, not weaken, the US central bank’s

commitment to achieving 2% inflation.

If the ECB does switch to a target range where the lower bound is clearly below 2%, inflation

expectations are likely to be affected. Moreover, as markets might start pricing in (premature)

policy normalization, we see a real risk of unwarranted currency appreciation and wider credit

spreads, and this would weigh further on inflation expectations.

Alternatives the ECB might discuss could include switching away from using HICP as the

reference price index. In particular, if the ECB were to target an inflation gauge that, in the

past, recorded consistently higher inflation rates than HICP inflation, this would make it easier

for the ECB to achieve 2% inflation. However, this would be a lowering of the inflation target in

all but name, and markets would react accordingly.

Searching for more clarity on limits and instruments

Tools: In order for it to be credible, any discussion of an inflation goal would need to be

accompanied by more clarity with regard to the instruments the ECB can deploy to meet its

price mandate. Given the peculiar institutional framework of the euro area and the constraints

that it imposes on non-conventional monetary tools, the ECB’s review would have to help

outline the policy scope for Ms. Lagarde if more stimulus is needed down the road. Therefore,

we think that such a review would need to assess how the ECB could disentangle itself from

its self-imposed limits, if they turn out to be inconsistent with the fulfillment of the central

bank’s price objective, but also identify additional assets the ECB could potentially add to its

balance sheet.

As for self-imposed rules, we think that the review will disclose which of the two main limits for

asset purchases (concentration limits and capital keys) could be amended if needed. We think

the ECB could gain flexibility by raising concentration limits on government bonds from their

current 33%, while the capital-key framework is probably more binding.

It is more difficult to assess how transparent the ECB will want to be with regard to assets that

could be potentially purchased. The arsenal is largely a function of what is regarded as

politically acceptable, and if fundamentals change, the line that separates acceptable from

unacceptable tools will move, as it happened in the past. In the current context, we think that

the ECB should not rule out getting involved in (senior) bank bonds and maybe even equities.

However, any such opening to broaden the scope of QE would likely say nothing about when

the GC would deem it appropriate to start buying these assets. We think the bar will be very

high for bank bonds and extremely high for equities. Instead, we expect there to be a clear

rejection of the idea that one day the ECB could engage in “helicopter money”.

The policy review might also touch on tools to mitigate the impact of negative rates on the

financial sector, specific aspects of ECB communication (such as whether to disclose GC

members’ views and votes) and whether the ECB wants to increase its presence in the

market for green bonds – Ms. Lagarde seems very supportive of the latter idea.




The policy agenda The European policy agenda for 2020 will be busy, with the completion of Banking Union,

reforming the European Stability Mechanism (ESM), addressing trade policy and setting a

new multi-year EU budget.

Banking Union The discussion surrounding the completion of the Banking Union with a common deposit-

guarantee scheme will continue to be highly complex with regard to striking the right balance

between risk reduction and risk sharing. The difficulty of solving the regulatory issue of how to

treat sovereign bonds on banks’ balance sheets leads us to think that a breakthrough with

regard to deposit insurance is not imminent.

Reform of ESM Reform of the ESM is based on four pillars: a common backstop to the Single Resolution

Fund, conditions for eligibility for precautionary credit lines, commitment to introducing single-

limb CACs into euro area government bonds issued starting from 1 January 2022, and the

ESM’s role in future financial-assistance programs. The new ESM treaty will come into force

when it has been ratified by all 19 ESM member states. At this stage, it is unclear whether the

whole proposed package will survive the approval process, but it is highly like that the ESM’s

role and prominence will increase going forward.

Trade policy Trade policy will also be in the limelight, with the new European Commission set to engage

shortly after Brexit in discussions with the UK on a free-trade agreement and having to deal

with the implications of the World trade Organization (WTO) ruling on a case involving Airbus

and Boeing. The WTO found that Boeing received billions of dollars of illegal subsidies in a

case dating back to 2005. Trade arbitrators are expected to allow the EU to impose its own

retaliatory tariffs on US imports. This would follow a US decision to impose punitive tariffs on

USD 7.5bn of imports from Europe on the back of the first leg of the WTO ruling, which dealt

with illegal subsidies received by Airbus.

New EU budget Last but not least, we expect the new EU budget for 2021-27 to reallocate funds from EU-

CEE to southern Europe due to the latter’s worse economic performance, higher youth

unemployment and bigger number of immigrants from outside Europe. Greece, Portugal and

Italy will likely receive the largest increase in euro terms. In contrast, CEE countries could see

their annual allotment decline by 0.2-1.0% of GDP per year, with Hungary and Poland the

most affected.




Germany



■ We expect GDP growth of 0.7% for 2020 and 0.8% for 2021, after presumably 0.6% for

this year. Note that the 2020 figure is artificially inflated by a higher number of working

days. Adjusted for this calendar effect, GDP growth is only 0.3%. The 2019 and 2021 data

are not distorted by such an effect.

■ In line with our global outlook, the export activities of German companies are likely to lose

further momentum in 2020 before a recovery sets in in 2021. In our baseline scenario, we

assume there will be neither any US tariff hikes on European cars nor any escalation in

US-China trade tensions. Hence, the forecast risks for German exports and the overall

German economy point to the downside (see the scenario analysis section for more details).

■ In 2020, downward pressure on exports and on capacity utilization in the manufacturing

sector is likely to dampen the capex spending of industrial companies. In 3Q19, capacity

utilization already decreased slightly below its long-term average of roughly 83.5% after

hitting its second-highest level in more than 25 years. As a result, more negative spillover

effects from the manufacturing industry into the services sector, which has been

comparatively robust so far, are likely. This in turn will further dampen total capex

spending, which services companies account for more than half of.

■ As a result, the labor market is likely to cool further, in line with the significant decline in

job vacancies. With an increase of 340,000 yoy, job creation has already been

significantly less brisk than it was at the turn of the year 2017/2018 (+660,000 yoy). As a

dampening factor, companies will probably shy away from layoffs and hold on to more

workers than necessary in the slowdown (labor hoarding). This would be a response to

the difficulty of getting qualified personnel in the past few years and the recurring costs of

hiring staff when growth picks up again in the medium-term. Reductions in hours worked

on a voluntary basis (overtime) or in the use of short-term benefits is therefore more likely.

Given the labor hoarding, wage increases should only decline somewhat to roughly 2%-

2.5% across sectors in 2020 and 2021 (2019: +3%). This, in turn, should help dampen the

impact of the negative labor market on private consumer expenditures.

■ The construction industry will probably remain a pillar of growth. Although there are signs

of overheating in some bigger cities, the demand for housing will continue to be strong. In

addition to the fundamental reasons for this strength, such as the process of catching up

after underinvestment in recent years and rising population, persistently low interest rates

are likely to contribute, as well.

CAPACITY UTILIZATION DECLINING JOB CREATION TO SLOW FURTHER

Source: Ifo, Labor Agency, UniCredit Research

70.0

72.0

74.0

76.0

78.0

80.0

82.0

84.0

86.0

88.0

90.0

199

2

199

3

199

4

199

5

199

6

199

7

199

8

199

9

200

0

200

1

200

2

200

3

200

4

200

5

200

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

201

4

201

5

201

6

201

7

201

8

201

9

Capacity utilization in manufacturing sector, in %

Long-term average

-200

-150

-100

-50

0

50

100

150

200

-600

-400

-200

0

200

400

600

800

1000

200

1

200

2

200

3

200

4

200

5

200

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

201

4

201

5

201

6

201

7

201

8

201

9

Employment, in 1,000 yoy Vacancies, in 1,000 yoy (rs)






Outlook for fiscal policy

Fiscal policy set to be moderately expansionary in 2020 and 2021

Germany’s debt brake limits fiscal growth impulse… …and cooling of labor market may limit fiscal flexibility further

Debt brake allows for higher public spending only under certain circumstances

We expect a moderately expansionary fiscal policy stance in 2020 and 2021. According to the

latest projection of the Stability Council, a joint body of the central government and the federal

states, the surpluses in the structural budget are likely to only gradually decline each year, to

0.5% of GDP in 2020 and then to 0.25% in 2021. Hence, the comparatively strong fiscal

impulse this year (around 0.6%), will probably not be sustained. Additional spending to tackle

climate change amounts to EUR 54bn from 2020 to 2023. However, this package will only

have a negligible net effect on growth, as the fiscal burden for companies and private

households will increase in turn. As in previous years, we expect public investment to grow at

a disproportionately high rate compared to GDP growth. However, these increases will still

remain far less pronounced than government savings due to declines in interest rates.

According to the Bundesbank, the public sector saved about EUR 370bn in interest

expenditures from 2008 to 2018 (public investment: EUR +26bn).

Both legal and political factors prevent the government from pursuing a strongly expansionary

stance. From a legal perspective, the debt brake enshrined in the constitution places tight

constraints on fiscal policy. Only a structural deficit of 0.35% of GDP is allowed. According to

the latest budget plans, an additional amount of about EUR 11-12bn per year from 2020 to

2023 could therefore (theoretically) be spent by the central government. This would equal a

non-negligible, but still limited, growth impulse of 0.3% of GDP per year compared to the

baseline scenario. Note that the federal states are even obliged to run a balanced structural

budget from next year onwards. In our view, the cooling of the labor market could limit the

degree of fiscal flexibility further, as the decline in income tax revenue may be stronger than

anticipated. Political reasons also speak against a fiscal boost. The CDU/CSU tries to attract

conservative voters by reining in public spending. Hence, an abrogation of the debt brake is

unlikely, since it would require a two-thirds majority in the Bundestag and the Bundesrat.

The debt brake only allows significantly higher discretionary public spending in the case of

deep recessions and natural disasters. Since the precise quantifications of economic pain

thresholds are not prescribed by law, the government has substantial room to maneuver. In

our view, the course of fiscal policy is only likely to change in the event of a decline of about

1% in GDP and/or a strong rise in the unemployment rate by roughly 1pp.

In such a risk scenario, the government may increase public spending and frontload the planned

cut of the solidarity surcharge from 2021 to 2020. In August, finance minister Olaf Scholz

suggested making additional expenditures of EUR 50bn in the event of an “emergency” (roughly

1.5% of GDP).

FISCAL POLICY ONLY SLIGHTLY EXPANSIONARY PUBLIC INVESTMENT RISING BUT BIG BANG UNLIKELY

Source: Federal Statistical Office, Stability Council, IMF, UniCredit Research

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Structural budget balance of government, in % of GDP

Projection of Stability Council

0

0.5

1

1.5

2

2.5

3

3.5

199

1

199

2

199

3

199

4

199

5

199

6

199

7

199

8

199

9

200

0

2001

2002

200

3

200

4

200

5

200

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

201

4

201

5

201

6

201

7

201

8

201

9*

Public gross fixed capital formation, in % of GDP; *1H19




France

Tullia Bucco Economist (UniCredit Bank, Milan) +39 02 8862-0532 [email protected]

■ We expect GDP growth to ease from 1.3% in 2019 to 1.0% in 2020, before regaining some

momentum in 2021 and settle at 1.2%. France’s comparatively smaller exposure to

countries that suffered the most globally, strong export specialization in aeronautics for

which demand, particularly from China, has remained robust, and sizeable fiscal stimulus

in favor of households will continue to be supportive factors. After a stable growth

performance at 1.2% annualized in the first three quarters of 2019, GDP will likely grow at

a 1.0% annualized pace through 1H20, before slowing further in 2H20 amid weakening

external demand.

■ Our forecast for a moderation in GDP growth in 2020 is mainly explained by a deceleration

in gross fixed investment (to 1.8% from a solid 3.4% in 2019), particularly of non-financial

corporations – their investment rate hit a record high in 2019 at 24%. The unwinding of the

one-off boost to profit margins stemming from the transformation of the tax credit for

competitiveness and employment into a permanent cut in employers’ social contributions,

is likely to lead to a softer pace of investment over our forecast horizon.

■ The deceleration in household residential investment will probably gather pace, reflecting,

among other factors, the refocusing of some support fiscal measures on areas of tight

supply. Nonetheless, the slowdown is likely to remain gradual given that financing

conditions and households’ capacity to buy are expected to remain favorable, on average.

Government investment is set to weaken in line with the local electoral cycle (municipal

elections are scheduled for March 2020).

■ As investment growth is set slow, the role of consumption as a key growth engine is likely

to strengthen. We forecast a moderate acceleration in private consumption (from 1.2% to

1.4% in 2020), as the sizeable fiscal stimulus targeting households (worth 0.7% of GDP in

2020) is likely to start filtering through to spending more decisively and to largely offset the

negative impact of a slowdown in employment. This baseline scenario rests on the

assumption that social discontent partly recedes from current levels.

■ The government’s fiscal stance is planned to be mildly expansionary in 2020 (worth 0.1%

of GDP), also reflecting the “exceptional circumstances” that led the Elysée to announce

additional fiscal measures in favor of low-to-middle-income households. We see upside

risks to the 2.2% deficit target included in the Budget Law due to limited details on

expenditure reduction plans and a likely slippage in GDP growth below government

forecast, which is more optimistic than ours.

A ONE-OFF FACTOR BOOSTED CORPORATE INVESTMENT ENCOURAGING IMPROVEMENT IN CONSUMER CONFIDENCE

Source: INSEE, UniCredit Research

-20

-15

-10

-5

0

5

10

15

-20

-15

-10

-5

0

5

10

15

4Q00 3Q04 2Q08 1Q12 4Q15

Gross operating surplus

Gross fixed capitalformation

2Q19

Non-financial corporations (yoy %, smoothed)

-6

-4

-2

0

2

4

6

60

70

80

90

100

110

120

130

Mar-99 Aug-02 Jan-06 Jun-09 Nov-12 Apr-16 Sep-19

Consumer confidence

Household spending on goods (yoy %, rs)

Household consumption (yoy %, rs)





Reform momentum faces hurdles

Social discontent is, once again, on the rise

Macron’s reformist drive is being put to a test “Act II” of Macron’s presidential term Addressing the divide between large urban areas and town and villages remains key

Halfway through his five-year mandate, French President Emmanuel Macron is facing a new

wave of social discontent after the yellow-vest protests that raged in the country until last

spring. This new wave of discontent was mainly triggered by the announcement of savings

targeting healthcare spending as part of the 2020 social security budget law, and the main

guidelines of a pension reform that aims to improve the system’s fairness by eliminating the

privileges enjoyed by a few categories of public workers (e.g. firefighters, policemen).

This flare-up of social unrest marks a setback for Mr. Macron, who in the past few weeks has

lost some of the popularity he had recovered since April at the cost of sizeable fiscal

concessions to yellow-vest protesters and a deviation from the ambitious fiscal targets he had

previously pledged. According to polls, the French population fears a deterioration of the

quality of institutions that make up the country, such as national health insurance, pension

insurance and education. Meanwhile, new defections within the parliamentary majority have

occurred, with some members questioning the seriousness of the ruling party’s commitment

to renewing politics and bringing about social change. Nonetheless, Mr. Macron can still count

on a solid majority and a very weakened opposition, which has shown on several occasions

that it is unable to capitalize on the government’s moments of difficulty.

The pension reform, which is expected to be adopted by parliament before next summer, is a

major test of the government’s ability to pursue reforms in the second half of Mr. Macron’s

term. In the past, other governments have had to abandon a reform of public-sector special

regimes in the face of street protests. However, Mr. Macron’s proposal to exempt workers

affiliated to these regimes from the reform to assuage the protests seems inconsistent with

the aim of improving equality among workers. The provision of preferential treatment to

public-sector workers has lost social and political legitimacy – the need to attract workers to

the civil service has vanished over time – and would deny the very logic of the reform, i.e.

improving the fairness of the system.

After mainly focusing on economic reforms in the first part of his term, Mr. Macron is now

expected to address reforms aimed at improving the functioning of parliament and reforming

the state, including a reduction in the number of MPs, the introduction of more proportionality

in parliamentary elections, and the possibility for local communities to set themselves apart

from national rules. However, these reforms face many hurdles. It is very unlikely that the

Senate, which is controlled by the center-right, would approve any of these measures limiting

its influence. Meanwhile, local authorities will hardly accept increased responsibility if this

were not accompanied by greater autonomy in the management of financial resources. This is

all the more likely as the Elysée’s recent decision to fully abolish the housing tax for all

households by 2023 will increasingly weigh on local finances.

Economic reform proposals to be discussed next year aim at providing a further boost to the

supply-side with the partial abolition of the production tax (which weighs on firms’

competitiveness), and at introducing new forms of “flexicurity” for individuals via the

establishment of a guaranteed basic income conditional on seeking work, which should merge

existing welfare entitlements. The main factor that can hinder the adoption of these reforms is

the limited resources the government can count on unless a major spending review (which is

currently not in the agenda) is carried out.

In the face of the deep social discontent expressed by the population, we think that one of the

government’s top priorities to maintain reform momentum is to foster measures aimed at

overcoming the territorial divide between “peripheral” territories and big cities on which

discontent built in the first place. This requires, as a minimum, strengthening existing policies

or adopting new ones in the field of housing, urban development and infrastructure with the

aim of ensuring public services are as uniform as possible across the entire country.




Italy Dr. Loredana Maria Federico Chief Italian Economist (UniCredit Bank, Milan) +39 02 8862-0534 loredanamaria.federico@ unicredit.eu

■ We expect Italy to face another year of weak growth in 2020, with real GDP expanding by

0.2%, a similar rate as in 2019, and recovering to 0.5% in 2021. Next year, exporters are likely

to (again) face flattish global demand (and weaker imports from the eurozone), and the

currency is not projected to act as a mitigating factor as it did in 2019. Capex is expected to

weaken further, while a recovery will continue to characterize other investment aggregates,

especially construction. We are penciling in an easing of financial conditions thanks to the

ECB’s package and lower government-bond yields, and this should prevent fixed investment

from becoming a drag on GDP. Private consumption is expected to drive growth, albeit at a

subdued pace, due to slowing job creation and increasing uncertainty as a result. Italy’s GDP

outlook is expected to improve in 2021, when a strengthening of world trade growth should

provide a fresh impulse to exports and capex.

■ Given subdued growth, we forecast that CPI inflation will remain below 1.0% in 2020-21. Still,

we expect core inflation to broadly stabilize around its current level (0.6-0.7%), as the expected

development of the output gap does not suggest a material deceleration.

■ Two main downside risks to our baseline scenario could lead to a recession in Italy. On trade,

while Germany is likely to be affected the most if the US imposes car tariffs on Europe, Italy

will not be immune: 1. Car exports to the US make up 27% of Italy’s total exports of cars,

although this accounts for only 0.8% of total Italian exports. 2. The share of car parts Italy

exports to Germany is significant (22%), on top of Germany’s position as Italy’s first trading

partner. On the domestic front, while we do not expect early elections, there is a non-negligible

risk that the governing parties will not be able to muddle through on the bumpy road ahead.

Uncertainty about the outcome of a new election could lead to a repricing of funding costs for

the government and banks, and this would be transmitted to the real economy.9

■ The fiscal outlook is expected to benefit from the low-yield environment. Risks to the 2020

budget deficit target are low. Should fiscal slippage emerge next spring, we see room for

public-spending cuts, or the government might be in the position to recalibrate the imple-

mentation of its policy measures aimed to reduce the tax wedge, stimulate investment and

promote family policy and social inclusion. In 2021, while we assume that the government will

search for measures to replace currently targeted VAT revenue (worth 1% of GDP), we don’t

expect the budget deficit/GDP to improve compared to 2020, as growth recovery is likely to be

slow. We forecast that public debt/GDP will increase modestly in 2020-21, as the interest rate-

growth differential will remain positive, although declining, leaving Italy in a disadvantageous

position compared to its main eurozone peers. Such an outcome also suggests that any extra

savings in terms of interest expenditure should be used to lift growth properly.

WEAK, BUT NOT FALLING ACTIVITY AFTER ALL THE CHANCE TO CATCH UP SHOULD NOT BE MISSED

Source: Markit, Istat, Eurostat, UniCredit Research

9See our Economics Thinking – Assessing the impact of Italy’s sovereign stress on the real economy, March 2019.

34

38

42

46

50

54

58

62

-4

-2

0

2

4

Oct-09 Oct-11 Oct-13 Oct-15 Oct-17 Oct-19

Italy's real GDP & composite PMI indicators (MA(3))

Italy's real GDP, yoy (%) Italy (rs)

France (rs) Germany (rs)

-2

-1

0

1

2

3

4

5

Germany France Italy Spain Portugal

Public debt: interest rate-growth differential (pp)

2010-14

2015-19

Eurozone avg. (2015-19)



https://www.research.unicredit.eu/DocsKey/economics_docs_2019_170126.ashx?EXT=pdf&KEY=C814QI31EjqIm_1zIJDBJO9CpigeANRPPyAn7LFmYng=&T=1




Politics (once again) could be a game changer Our baseline scenario does not include snap election

Political uncertainty is expected to remain a key theme in our outlook. The scenario we see as most likely involves Italy avoiding an early election over the forecast horizon. The window for calling an early election will close at the end of 1H21, as Italy’s constitution does not allow parliament to be dissolved in the six-month period before the mandate of the current President of the Republic ends (the so-called blank semester). Our baseline scenario also takes into account that, should the current government headed by Prime Minister Giuseppe Conte collapse, political parties (probably with the exception of the League and the right-wing Brothers of Italy) will likely attempt to form another government during the current legislative term. Therefore, a government crisis might generate some market instability, but we would expect this to be temporary if early elections are avoided. Still, we predict that the road ahead will bebumpy, and the probability of early elections is not negligible.

The following are the main reasons: The high political cost of approving the 2020 budget plan

The current government, based on an alliance between the Five Star Movement (M5S) and the Democratic Party (PD), along with support from former Prime Minister Matteo Renzi’s new liberal movement, Italy Alive, and the left-wing Free and Equal party, has presented Italy’s 2020 draft budgetary plan. As is usually the case when tough decisions have to be taken, the share of the vote projected to go to the two main parties of the coalition (M5S and PD) is now lower than it was in August 2019. One could argue that a further decline in their projected vote shares, as suggested by opinion polls, might exacerbate instability within the ruling coalition, and MPs might find it more convenient to bring down the government to stop the draining of electoral support for their respective parties. However, we think it would be much more advantageous for MPs to assume that the government agenda might eventually pay off, and this might help rebuild consensus over the next two years. This is also because, in the case of the M5S, for example, the difference between its vote share in the March 2018 election (about 32%) and its average vote share in polls in 3Q19 (19%) shows that the political disposition of the more unstable portion of its electorate has already shifted.

The strong benefit of the low-yield environment

In the same vein, the formation of a new government has accelerated a reduction in government-bond yields, with the 10Y BTP-Bund spread hitting a low of 130bp in October 2019. Low yields, also due to the benefits from a new round of quantitative easing by the ECB, present a nearly unique window of opportunity in terms of public resources to be saved, one that could prove costly if squandered by the governing parties.

The outcome of the next election suggested by the polls

We assume that it will not be easy for the political parties within the ruling coalition to find rapid agreement on how to replace the current electoral law, and, eventually, on how to promote a return towards a more proportional system – a goal that is part of the government’s program. We think that this will create a disincentive to call elections in the short term. The current electoral system, the Rosatellum, is characterized by a mix of majoritarian and proportional representation, according to which about 40% of seats are assigned on a single-district, first-past-the-post basis. Based on current opinion polls – and as long as the candidates of the center-right parties are supported by a pre-election coalition – a scenario could materialize in which the center-right coalition wins most of the first-past-the-post districts in addition to gaining proportional representation of roughly 50%.10 The M5S and the center-left parties could end up with significantly reduced influence in the next parliament, as opposed to having more than about 55% of the seats in the current legislature.

Still, the political outlook is highly uncertain and… …we see destabilizing factors threating the longevity of parliament

However, the governing parties do not form a cohesive coalition, and the government’s program is too vague to mitigate possible causes of conflict that have been emerging and are likely to continue to emerge in the coming months. Therefore, a political accident could occur: one that could lead to a government collapse, the lack of an alternative majority, and a snap election. We have identified at least four destabilizing factors that could support a risk scenario, with a non-negligible probability of an early election taking place over the forecast horizon.

10

Winning 40% of the vote in the proportional system and 60% of the first-past-the-post districts could be enough to achieve a nearly absolute majority in parliament.




1. The outcome of regional elections, starting at the end of January

Italy will hold several important regional elections next year, starting in Emilia Romagna and

Calabria (26 January) and continuing with Campania, Liguria, Marche, Puglia, Toscana and

Veneto. All of these regions, except for Liguria and Veneto, are currently governed by center-left

parties. Therefore, defeats in some of them – with Emilia Romagna (a stronghold of the PD) first

in line – could put the governing parties under severe stress.

2. A possible referendum to change the electoral law

The beginning of 2020 is also expected to provide clarity as to whether it will be possible to

promote the referendum requested by the center-right to abolish the proportional part of the

Rosatellum, and thereby changing it into a purely majoritarian system. Should such a

referendum be scheduled (most likely for next spring), this could accelerate attempts by

governing parties to change the electoral law and reduce the scope of such a referendum.

Given the still-divergent positions within the ruling coalition with regard to how to change the

electoral system, such acceleration could fuel instability and will require party leaders to exhibit

a degree of political savvy in order to navigate such thorny issues. A scenario in which the

referendum on the Rosatellum is held, only the center-right parties campaign for change and

the referendum passes, would present further opportunities for opposition parties to consolidate

their positions and thereby destabilize parliament.

3. The constitutional amendment to reduce the number of MPs

In the first half of 2020, the next steps to definitively approve constitutional reform aimed at

reducing the number of MPs will also be taken.11

If such a constitutional amendment is passed,

it will lead to a 37% reduction in the number of seats in Italy’s parliament, significantly reducing

the ability of leaders of political parties to guarantee a role for party members in parliament in

the next legislature. Therefore, a scenario in which an early election hinders the completion of

the approval process cannot be ruled out. In January, it should become clear whether the

requirements to have a confirmative referendum have been met. If this is not the case, the last

steps needed to approve the reform will probably be taken in February and March. Otherwise,

they will probably be postponed to late spring. Both periods could be marked by a sharp

increase in political uncertainty.

4. The appointment of a new President of the Republic

When 2021 arrives political parties will shift their focus to the election of the President of the

Republic, which is scheduled for the beginning of 2022. The chance to nominate a candidate for

the presidency could be seen by political leaders as a very prominent achievement. Therefore,

the prospect of such an appointment could increase pressure on the opposition parties to fuel

such political instability that Italy is compelled to hold a snap election before July 2021.

A risk scenario with a non-negligible probability

Should the risk scenario materialize, with Italy holding an election over the forecast horizon,

current opinion polls suggest that the League, the Brothers of Italy and Forza Italia will probably

gain an absolute majority in the next parliament, with the final outcome conditional on the

electoral system in place. The key points of such a coalition’s economic agenda are expected to

be focused on a swift and significant tax reduction and on boosting public investment. Its fiscal

stance and, above all, approach to the European Commission in terms of compliance with EU

budget rules (constructive vs. confrontation) are likely to remain much less clear. Still, given that

the outcome of the European Parliament election in May 2019 affirmed the supremacy of

Europe’s mainstream parties, we see little incentive for a potential center-right/right government

in Italy to pursue anti-EU rhetoric. Such parties are more likely to espouse the position that they

will try to change the eurozone and Europe from within. This is expected to leave investor

concerns mainly centered on fiscal sustainability in the medium term.

11

While the process of approval for this constitutional reform has already been concluded in parliament, a confirmative referendum can be requested so that the

constitutional amendment can be definitively approved. In addition, the reform envisages a two-month period in which the government will have to act to adapt current features and organizations of parliament to the lower number of MPs.




Spain


■ We expect the Spanish economy to grow by 1.4% in 2020 and by 1.5% in 2021, down from

1.9% this year. Recent national account revisions point to weaker growth momentum than

previously assumed, particularly as a result of less-vibrant domestic demand. Over the last

three quarters, households have significantly increased their savings rate, from around 5%

to above 7% – an increase that might reflect both precautionary motives in the face of a

more-challenging global environment and a genuine rebound after the lows recorded

during the recovery. However, the slowdown in domestic demand has also come from

investment. Weakness in the manufacturing sector since mid-2018 has had an adverse

impact on growth in equipment investment.

■ Going forward, we expect the savings rate to stabilize around current levels throughout the

forecast horizon, but there might be room for a further increase especially in case of a

deterioration in consumer confidence stemming from both a less-bright labor market and a

more-challenging global environment. Investment is likely to decelerate amid trade

tensions and weak global growth, albeit high levels of capacity utilization and favorable

financial conditions remain very supportive. Construction investment is likely to lose

momentum as the economic cycle matures. On the external-demand front, we estimate

that net exports will modestly contribute to GDP growth. Indicators for foreign orders from

Spain’s main export regions – including the euro area, which is Spain’s main export market

– point to a continuation of this slackness in the near future.

■ The labor market is losing some shine as a result of a cyclical slowdown. The latest data

on Social Security registrations point to a slowdown in employment, which started during

the summer. This employment slowdown, which has been relatively broad-based across

sectors, has been somewhat more pronounced in construction and industry. While the

pace of job creation is likely to decline, we still expect the unemployment rate to drop

below 13% by 2021.

■ The political stalemate in Spain has been weighing on public finances. The 2018 budget

was rolled over into 2019. We now expect something similar to happen also in 2020, with

the budget deficit set to reach 2.2% of GDP next year (this is based on a scenario in which

legislation remains unchanged, taking into account a less-benign macro outlook). This

projection includes the wage increase for public employees stipulated for 2018-20 and an

annual pension revaluation that is in line with inflation. Overall, the fiscal stance of Spain is

expected to remain broadly neutral throughout our forecasting horizon.

HOUSEHOLDS BOOST SAVINGS LABOR MARKET BECOMES LESS BRIGHT

Source: Eurostat, INE, UniCredit Research

0

4

8

12

16

-6.0

-3.0

0.0

3.0

6.0

4Q00 1Q02 2Q03 3Q04 4Q05 1Q07 2Q08 3Q09 4Q10 1Q12 2Q13 3Q14 4Q15 1Q17 2Q18

Real disposable income (in % yoy)

Real household consumption (in % yoy)

Savings rate (as % of disposbale income, RS)-30

-20

-10

0

10

20


Affiliates to social security by sector (yoy; %)

Construction Industry Services Total





The political stalemate is set to continue

Different coalition scenarios At the time of writing, after an inconclusive election – with Ciudadanos almost being wiped out

and the far-right Vox doubling its support – the PSOE and Podemos have been working on a

coalition government that will assign top ministerial posts to both parties. Since together the

two parties are 21 MPs short of having an absolute majority in Spain’s 350-seat parliament,

they will have to rely on external support or abstention on the part of other parties. Without

important political concessions, particularly with regard to Catalonia’s independence, such a

government will struggle to take off. If it were to find its feet, it could be short-lived. Hence, a

grand coalition between the People's Party (PP) and PSOE, which would enjoy more

comfortable parliamentary arithmetic, might eventually emerge in order to guarantee some

governability and to stem the advance of the far right.

Loss of reform momentum A weak government in a highly fragmented parliament at a time when economic growth is

decelerating is likely to slow the implementation of important structural measures necessary

to consolidate the banking system, to further overhaul Spanish labor law and to address

factors that might impair productivity in the medium and long term. This might create growth

challenges for the country going forward. Given a wide scoreboard of indicators that capture

different dimensions of Total Factor Productivity, which is the main driver of growth in the long

run, Spain hardly ranks close to best-in-class and is actually closer to an economy like Italy.

The Catalan stumbling block Moreover, Spain’s future government might lack the necessary resolve and cohesiveness to

tackle rising secessionist tensions in Catalonia. Social unrest recently resurfaced in the region

when, last October, Spain's Supreme Court sentenced nine Catalan separatist leaders to

between nine and 13 years in prison for sedition. Catalan independence might represent the

main stumbling block for the stability of any coalition government, as the main parties have

radically different views on the issue. PP and Vox do not want to get into negotiations with

Barcelona to reform the legal status of the region, whereas Podemos wants to hold another

independence referendum in Catalonia. PSOE, instead, supports constitutional reform that

shifts the current system of autonomous rule towards a federalist system – this is likely to be

the only acceptable compromise for both Madrid and Barcelona to stabilize the situation.

System of autonomies vs. federalist solution

Under both a system of autonomies and a federalist system, regions have parliaments with

legislative powers and possess competencies in key social policy areas such as health,

education, culture and so on. However, in a state of autonomous rule, the central government

can heavily interfere in the domestic affairs of the autonomous region. For example, it has the

power to impose its policies across regions and control all tax revenues, redistributing them

locally with a high degree of discretion.

PARLIAMENT BECOMES EVEN MORE FRAGMENTED CATALANS QUESTION THE STATUS QUO

Source: Ministry of Interior, CEO Catalunia, UniCredit Research

0 175 350

November election

April election

Number of seats in lower house

Podemos PSOE Others Ciudadanos PP Vox

Absolute majority

0

10

20

30

40

An independent state An autonomouscommunity

A state in a federalSpain

A region of Spain

Do you believe Catalonia should be...

*Poll conducted by the Generalitat de Catalunia

Status quo

% respondents




Austria

Stefan Bruckbauer Chief Austrian Economist (Bank Austria) +43 505 05 41951 stefan.bruckbauer@ unicreditgroup.at

Walter Pudschedl Economist (Bank Austria) +43 505 05 41957 walter.pudschedl@ unicreditgroup.at

■ At an estimated growth rate of 1.5%, the Austrian economy has lost considerable

momentum in 2019 compared to the previous year. The unfavorable international

environment, such as the slowdown in global trade, the weakening German economy and

economic-policy uncertainties (trade-policy conflicts, Brexit, etc.) have dampened export

dynamics and put pressure on industrial development. Investment has lost momentum in the

course of the year, especially investment in equipment. Private consumption has remained

the most important driver of growth and, supported by fiscal measures (e.g. a reduction in

health insurance contributions for low-income earners), will continue to be the main pillar of

economic growth in 2020 and 2021. Given the ongoing weakness of the global economy, we

expect the very long investment cycle to come to an end. However, favorable financing

conditions and above-average capacity utilization should prevent a slump. In the difficult

global environment, net exports will hardly be able to contribute to growth in the coming

years, which we expect to be well below potential at 1.0% in 2020 and 1.3% in 2021.

■ Weaker growth will put an end to the improvement in the Austrian labor market. After the

decline in the unemployment rate to 4.6% in 2019, we expect a slight increase to 4.7% in

2020, due to a decline in employment growth to below 1% year-on-year, which is thus not

sufficient to compensate for the increasing supply of labor. For the first time since 2016, the

unemployment rate will likely rise again in 2020, but should stay at 4.7% in 2021 as well.

■ Supported by the low oil price, inflation fell in the second half of the year. For 2019, we

expect an annual average inflation rate of 1.5%, after 2.0% in the previous year. As a result

of lower economic growth, inflationary forces will hardly be felt in 2020 and 2021, and there

is hardly any upward momentum in sight from the external side either. We expect the

inflation rate to stay at 1.5% in 2020 and to rise slightly to 1.8% in 2021.

■ Following the first surplus in the general government budget since 1974 of 0.2% of GDP in

2018, the financial year 2019 should also close with a slight surplus of 0.5% of GDP. Due to

weaker growth and some recent decisions in the Austrian parliament, partly on the eve of

snap elections (e.g. noticeable pension increases), we expect the budget balance to

deteriorate in 2020 and 2021, but still consider a slight surplus to be possible. At the end of

2021, total public debt will presumably amount to only around 65% of GDP.

ECONOMIC GROWTH TO FALL BELOW POTENTIAL THE OIL PRICE WILL CONTINUE TO DAMPEN INFLATION

Source: Statistik Austria, UniCredit Research

2.5 2.4

1.5

1.0

1.3

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

2017 2018 2019E 2020F 2021F

Net exports Investment Public consumptionPrivate consumption Change in inventories GDP yoy (%)

Contribution to GDP change in %-points

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Jan-17 Aug-17 Mar-18 Oct-18 May-19 Dec-19 Jul-20 Feb-21 Sep-21

Transport Housing, energy Food Other effects Total CPI

Foreca

Forecast








CEE

Outlook shaped by external risks

Dan Bucsa, Chief CEE Economist (UniCredit Bank, London) +44 207 826-7954 [email protected]

■ In EU-CEE12

, we expect economic growth to slow to 2.6% in 2020 from 3.6% in 2019,

affected by weaker global trade and a cyclical downturn in the US. Economic growth could

recover to 2.8% in 2021 if global trade rebounds (Charts 1 and 2). Growth in the western

Balkans will follow the same trajectory as in EU-CEE. We expect rate cuts in Czechia and on

hold in all other EU-CEE countries and Serbia.

■ Growth in Turkey is likely to pick up gradually to around 2% in 2020 and 3% in 2021,

remaining below potential in both years. The CBRT may cut its policy rate to 10% or lower,

keeping the real interest rate close to zero. In Russia, economic growth could remain below

1.5% in 2019-20 if investment under the national projects fails to start. We expect the CBR

to cut the policy rate to 5.75% or below in 2020 as inflation remains below the 4% target.

■ The main political risks will be a smaller EU fund allotment to central Europe, thwarted

European integration in the western Balkans and US sanctions in Turkey and, to a lesser

extent, in Russia.

Domestic demand will remain the biggest growth driver in EU-CEE

In EU-CEE, 2020 will further highlight the gap between strong domestic demand and weak

exports. A dense election cycle is coming to an end and, as a result, fiscal impulse could

peak in the first half of 2020. Although private consumption has been the strongest and most

stable contributor to economic growth for four years, it has received additional support from

wage and pension increases. Fast income growth will help households weather external

headwinds at the beginning of 2020. Eventually, weaker exports will affect industrial

production and wage bargaining, even after the expected recovery in global trade at the

beginning of 2021.

CHART 1: GROWTH BELOW POTENTIAL IN 2020… CHART 2: … WITH A RECOVERY IN 2021

Source: Eurostat, national statistical offices, UniCredit Research

Labor market tension is easing

In fact, labor market tension is already easing in EU-CEE. The manufacturing sector is the

most affected due to slowing exports (Chart 3). Current vacancy levels are still close to all-

time highs, with construction standing out, but the combination of slower wage growth in the

private sector and smaller raises in the public sector is expected to weigh on consumption.

12

EU-CEE comprises Bulgaria, Croatia, Czechia, Hungary, Poland, Romania, Slovakia and Slovenia – all CEE countries that are members of the EU.

-2.0 -1.0 0.0 1.0 2.0 3.0 4.0 5.0

Russia

Slovakia

Slovenia

Czechia

Turkey

Romania

Croatia

Serbia

Hungary

Bulgaria

Poland

Private consumption Public consumption Fixed investment

Net exports Inventories, error GDP

yoy (%),pp

-2.0 -1.0 0.0 1.0 2.0 3.0 4.0 5.0

Russia

Slovakia

Slovenia

Czechia

Turkey

Romania

Croatia

Serbia

Hungary

Bulgaria

Poland

Private consumption Public consumption Fixed investment

Net exports Inventories, error GDP

yoy (%),pp





More open economies first to slow due to weaker exports…

… which will affect investment…

… due to little scope for fiscal stimulus in 2020-21…

The more open economies such as Czechia, Hungary, Slovakia and Slovenia will be hit first,

with domestic demand expected to slow significantly already in 1H20. The disruption in global

supply chains will affect these countries more than the rest of the region, as their exports have a

higher content of imports. Since EU-CEE producers are price takers, higher production costs

could continue to eat into margins and profits, reducing investment. In the four countries, poor

external demand could delay some FDI projects, especially greenfield ones. In bigger

economies such as Poland and Romania, where domestic demand makes a larger contribution

to GDP, the slowdown may be more pronounced in 2H20. However, their recovery in 2021 is

likely to be more muted as well. Finally, Croatia and Bulgaria could be less affected by the

slowdown in eurozone growth than countries in EU-CEE of similar size due to their weaker

integration into eurozone production chains, especially in car manufacturing.

Throughout EU-CEE, capex is expected to decelerate in 2020, recovering in 2H21 when

global trade should be in better shape. Moreover, FDI could be dominated by intercompany

debt. During downturns, eurozone companies transfer cheap loans to their subsidiaries in EU-

CEE without charging the country risk, as banks have to do. EU funds will be the main tool to

offset this cyclical slump in private investment, with the end of the current EU budget in 2020

likely to boost inflows in 2020-21. However, experience from 2012-14 showed that EU-funded

investment at the end of the current EU budget tends to be less efficient and contribute less to

potential growth.

Fiscal policy will have little leeway to boost investment in 2020-21. Czechia and Bulgaria are

exceptions in terms of existing fiscal space, though not necessarily when it comes to actual

infrastructure spending. Governments increased public outlays too soon, with fiscal impulses

peaking in 2020 (Chart 4). Crowded out by social and wage spending, public investment is

also suffering from misallocation. In the run-up to elections, governments tend to divert funds

from nationally-important infrastructure projects to small projects that become a source for

graft and bribes to local authorities. As a result, the biggest infrastructure investment, namely

the introduction and expansion of 5G networks, is likely to be private as well in 2020-21.

CHART 3: LABOR MARKET SHORTAGES EASING IN EU-CEE CHART 4: FISCAL IMPULSES PEAKED TOO SOON

Source: national statistical offices, central banks, AMECO, UniCredit Research

… and also consumption

Slower wage growth may impact consumption, since the 2017-19 spending spree was

financed mostly through income growth rather than borrowing. Even though monetary

conditions will remain accommodative, we do not expect lending to accelerate in order to

offset weaker consumption. For the same reason, the absence of significant household

leveraging, the risk of real estate bubbles popping in EU-CEE is much lower than it was

during the global financial crisis. The only places where house prices adjusted for wage

growth are higher than they were before the global financial crisis are Prague and Budapest,

which hare both strong investment markets.

-10.0

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

Co

nstr

Ind

Constr

Ind

Constr

Ind

Constr

Ind

Constr

Ind

Constr

Ind

Constr

Ind

Constr

Ind

BG HR CZ HU PL RO SK SI

Range (2000-19) 4Q19Companies facing labour shortages, balance of answers (yes-no), %

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

HU RS SI HR SK PL TR RO RU CZ BG

2019F 2020F 2021Ffiscal impulse, % of GDP




Western Balkan slowdown similar to that in EU-CEE

Western Balkan countries could be hit harder by external weakness. Lack of access to the

European common market and to steady sources of FDI could lead to choppy growth rates.

Political uncertainty and the cyclical downturn in Europe will remain a drag on growth. Thus,

public infrastructure spending is likely to dominate investment, while households will benefit

from better income growth as governments reverse some of the recent fiscal tightening.

Low growth in Russia without a boost to investment spending

Better insulated from external risks, Russia is struggling to evade the constraints of its low

potential growth. If investment under the national priorities announced by President Vladimir

Putin in 2018 does not start, GDP growth could remain below 1.5% in 2020-21, leading to

further divergence from Europe and other EM. That said, there is scope for better growth

ahead. Russia’s adjustment to previous commodity price shocks, large reserves and a fiscal

breakeven oil price of around USD 45/bbl would allow the government to raise fiscal spending

even if commodity prices fall further from their current levels.

Gradual recovery in Turkish growth

Turkey’s exit from recession may be followed by faster growth rates of 2.2% in 2020 and 3.1%

in 2021. However, a return to potential growth of more than 4% per year is unlikely in the

absence of structural reforms. This means that unemployment will continue to rise and the

negative output gap will widen further. As Turkey is over-reliant on fiscal spending and bank

lending, growth is likely to fluctuate with global financial conditions and investor appetite for

lending to emerging markets. While companies rolled over all their long-term liabilities in

2019, potential corrections in equity prices in the US (see Cross Asset Strategy section) could

curb credit flows to Turkey. Banks rolled over around 60% of their long-term foreign funding in

2019, a signal that there is not yet appetite for releveraging.

Inflation to peak in 1Q20 and return thereafter to within target ranges in EU-CEE

Headline inflation is expected to peak in 1Q20 throughout EU-CEE due to a base effect in fuel

prices combined with above-target core inflation. The peak will very likely see inflation leave

target ranges temporarily. However, low imported inflation from the eurozone and the global

slowdown we expect could combine to keep inflation inside target ranges in 2020-21 (Chart 5).

There will be differentiation in disinflation, with Czechia likely to have the lowest inflation rate

among EU-CEE countries outside the eurozone. In Poland and Hungary, disinflation could be

more limited due to a significant fiscal impulse and very loose monetary conditions,

respectively. The outlier is Romania, where inflation could miss the target for three

consecutive years (2019-21) if gas and energy prices are re-liberalized.

The NBP, the NBH and the NBR expected on hold in 2020-21 Potential rate cuts in Czechia if growth and inflation slow

Thus, we expect the NBP, the NBH and the NBR to be on hold throughout 2020-21 (Chart 6),

although monetary conditions in these countries will be significantly different. A very orthodox

approach to monetary policy means that the NBP is likely to pit inflationary risks against lower

growth and external factors, with the result being stable interest rates and a PLN that will

remain slightly undervalued and trading above EUR-PLN 4.30 for the most part.

The NBH’s preference for loose monetary conditions and the active use of FX swaps to provide

HUF liquidity could translate into very low BUBOR rates, combined with gradual HUF

depreciation throughout 2020-21. The latter may be needed to offset the elimination of the

corporate sector’s savings surplus due to central bank lending schemes and poor exports,

especially in 2020. The low cost of carry will keep the HUF as the preferred short in the region.

The NBR will maintain a combination of negative real interest rates and RON real

appreciation that bodes ill for disinflation and exports. Due to strong domestic demand and

likely price increases ahead, inflation expectations will remain loosely anchored. Gradual

RON depreciation to the EUR-RON 4.90-5.00 range by 2021 will be insufficient to offset the

loss of external competitiveness, evident especially when adjusting effective exchange rates

with unit labor costs. Thus, Romania’s exports could remain the weakest in EU-CEE.

The CNB will start 2020 with a hawkish bias that is likely to wane once inflation starts falling from

its 1Q20 peak. An outright dovish bias could emerge if exports turn out to be weaker than in the

CNB’s extremely optimistic scenario. In a scenario of lower inflation and lower growth, the

proactive CNB Board is likely to cut interest rates already in 2020. Higher nominal and real

interest rates than in the rest of central Europe could help the CZK outperform its regional peers.




The NBS on hold

In Serbia, the central bank may cut interest once more to 2% before the end of 2019 and

keep the policy rate at that level in 2020-21. Serbia is a latecomer to the domestic demand

boom in CEE and, as a result, the output gap remains close to zero and is failing to exert

pressure on consumer prices. Absent large supply shocks, inflation could stay below the 3%

target in 2020-21 and the NBS may have to lower its target in the coming years. At the same

time, the currency remains overvalued and vulnerable to volatile capital flows due to the large

C/A deficit. If FX-index lending slows, the pressure will rise on the RSD.

The CBR is expected to cut the key rate to around 5.75% in 2020… … and the CBRT could keep the real interest rate close to zero

In Russia, inflation is unlikely to return to the 4% target in 2020. With growth close to potential,

domestic demand will exert muted pressure on prices. As inflation expectations and the FX

pass-through decline, inflation could struggle to return to target sustainably and the CBR may

have to lower its target in the next two years. Meanwhile, more rate cuts are likely, to at least

5.75% by mid-2020. Further easing would be warranted if the central bank again reassesses

its high estimates of equilibrium rates as risk and potential growth assessments decline. The

RUB is close to fair value and could remain close to current valuation levels in 2020-21.

In Turkey, the CBRT is returning to its near-zero real-interest-rate policy of yesteryear. After a

short-term spike above 10% in 1Q20, we expect inflation to stabilise in the high single digits in

2020-21, meaning that the policy rate could be cut to (or slightly below) 10%. Risk appetite for

EM assets and financial conditions in core markets will continue to shape TRY volatility. Thus,

we expect the TRY to weaken faster towards the end of each half of next year. However,

inflation may outpace nominal depreciation in both 2020 and 2021, reducing some of the TRY

undervaluation. Due to the credit-driven growth model and reliance on foreign funding, the

TRY will remain the currency in CEE that is most vulnerable to abrupt changes in risk

appetite, especially if stronger domestic demand drives the C/A into a deficit again.

CHART 5: INFLATION CLOSER TO TARGETS BY 2020 CHART 6: POLICY RATES STABLE OR FALLING IN 2020-21

Source: statistical offices, central banks, UniCredit Research

All EU-CEE countries to lose funds in the 2021-27 EU budget

Political risks will continue to weigh on CEE in 2020-21. For EU-CEE, negotiations for a new

EU budget are unlikely to yield a better outcome for the Visegrád four. While the other

countries will see their nominal allocations increase, there will be declines across the board in

percent of average GDP for 2021-2713

. Cuts in the EU fund allotment will be 0.2-0.3% of GDP

per year in Romania, Bulgaria and Slovenia and 1.0-1.1% of GDP in Hungary and Poland.

The impact on GDP growth will depend on how countries time EU fund inflows. Thus, active

spenders from EU funds like Hungary could bear the brunt in 2022-25, while the impact will

be larger in 2027-28 for late spenders such as Czechia and Romania.

13

For details, please see the CEE Quarterly – A moment of reckoning from 27 June 2018, pages 17-23.

0

2

4

6

8

10

12

HR SI BH SK RS CZ BG PL HU RU RO TR

2019E 2020F 2021F Inflation targetannual inflation (eop, %)

0.0

3.0

6.0

9.0

12.0

15.0

HU PL CZ RS RO RU TR

2019E 2020F 2021Fpolicy rates, %

https://www.research.unicredit.eu/DocsKey/emergingmarkets_docs_2018_165247.ashx?EXT=pdf&KEY=l6KjPzSYBBGzROuioxedUMk3cG4HXgdVWxS7XthGD4f9yF-8UG4cnw==&T=1




Western Balkans need an EU accession roadmap to avoid economic and political turmoil

Risk of limited US sanctions on Turkey…

…and falling risk of US sanctions on Russia

The decision not to grant Albania and Northern Macedonia a roadmap for EU accession will

impact politics in the western Balkans while also weakening reform momentum. The best

outcome would be a rapid adoption of the seven-stage accession model proposed by the

French administration14

(the suggested deadline is January 2020). These stages are 1. rule

of law, fundamental rights, justice and security; 2. education, research and space, youth,

culture, sports, environment, transport, telecommunications and energy; 3. employment,

social policy, health and consumer protection; competitiveness; 4. economic and financial

affairs; 5. internal market, agriculture and fisheries; 6. foreign affairs; and 7. other matters.

Fulfilling requirements under this scheme would grant gradual access to EU markets and

institutions, while hopefully preventing economic divergence and increased political turmoil.

Turkish President Recep Tayyip Erdogan’s determination to install S-400 missiles may lead

to US Congressional sanctions, although US President Donald Trump seems less keen on

punishing the Turkish administration. While sanctions remain a risk, they seem to be less of a

drag on appetite for Turkish assets than they were for most of 2019. Punitive measures may

be confined to certain people and institutions rather than being far reaching and a risk to

market stability.

According to the US Congress, Russia could still face sweeping sanctions if there is evidence of

interference in the 2020 elections. The risk might be mitigated by the ever-increasing numbers

and sources of fake social media accounts involved in the US election campaign on all sides.

14

For details, please see The non-paper “Reforming the European Union accession process” from November 2019.

https://www.politico.eu/wp-content/uploads/2019/11/Enlargement-nonpaper.pdf




UK

Persistent Brexit uncertainties, sluggish growth


■ We expect UK GDP growth of 1.3% in 2019, 0.8% in 2020 and 0.9% in 2021. The subdued

growth outlook reflects a continuation of Brexit uncertainties, weaker global growth and an

adjustment to a less open UK economy.

■ The BoE will likely cut the bank rate by 75bp to zero in 2020 and keep it there in 2021.

Brexit uncertainties and weaker global growth

UK GDP growth has been particularly volatile due to Brexit developments, but underlying

growth has weakened. Quarterly GDP growth averaged only 0.2% in the first three quarters of

2019, down from an average of 0.4% in 2018. Business surveys have been consistently

weak, and the composite PMI remained below 50 in October. Brexit-related uncertainties and,

in part, subdued global growth are likely responsible for the weakness.

The new Brexit deal foresees a less open UK economy

The UK government and the EU agreed a revised Brexit deal in mid-October. As a result, the

probability of a no-deal Brexit happening before end-2020 is now approximately zero, and the

effective sterling index rose accordingly. However, Brexit uncertainties will linger. The UK

government suspended legislation to implement the Brexit deal when MPs rejected its

accelerated timetable; the EU granted the UK a three-month Brexit extension to 31 January 2020;

and MPs triggered an early general election for 12 December. The election will effectively be

a proxy referendum on Brexit. The revised Brexit deal foresees a much looser future

relationship between the UK (excluding Northern Ireland) and the EU. This is based on a

simple free trade agreement (FTA), little or no regulatory alignment and the downgrading of

“level playing field” rules that will make it harder to agree a deep FTA with the EU, resulting in

higher long-run costs compared to former UK Prime Minister Theresa May’s deal.

Base case: Conservatives win a majority, and the UK leaves the EU with Mr. Johnson’s deal

Our base case scenario envisions the Conservative party winning a majority of seats in the

12 December election for three main reasons: 1. Opinion polls put the Conservative Party in

the lead by a vote-share margin of around 10-15pp over the Labour Party. This is likely a

large enough lead for it to win a majority of seats. 2. The leadership approval rating of Labour

leader Jeremy Corbyn is extremely low – the lowest of any opposition leader since Ipsos Mori

began polling in 1977. 3. The remain vote is more split than the leave vote, even more so now

that the Brexit Party has stood down its candidates in the 317 seats the Conservatives won in

the 2017 general election. If so, the UK will leave the EU by 31 January 2020 with UK Prime

Minister Boris Johnson’s Brexit deal. Still, anything can happen in the remaining three weeks

of the campaign.

THE LABOR MARKET HAS TURNED CONSERVATIVE PARTY IN THE LEAD

Source: Office for National Statistics, various opinion polls, UniCredit Research

-300

-250

-200

-150

-100

-50

0

50

100

150

200

-800

-600

-400

-200

0

200

400

600

800

1,000


Employment Vacancies - rs

thous.,change yoy thous., change yoy

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Aug-19 Sep-19 Oct-19 Nov-19

Con Lab SNP Lib Dem Brexit

If there were a general election tomorrow, which party would you vote for?

Snap general election announced for 12 December





Brexit uncertainties will persist

Under Mr. Johnson’s Brexit deal, the UK would formally leave the EU and enter the standstill

transition period to end-2020. During this transition period, the UK would be treated as if it

were an EU member state (except the UK will have no voting rights) and, thus, market access

would not change from current arrangements. However, since the future UK-EU relationship

will almost certainly take much longer than 11 months to conclude, ratify and implement, it

raises the risk of a hard Brexit happening on 1 January 2021. The withdrawal agreement

provides the option to extend the standstill transition period once for either one or two years

by mutual consent of the UK government and the European Council, with the decision due to

be taken by 1 July 2020. Mr. Johnson has ruled out an extension, and, for several reasons

(including those involving timing and politics), an extension of the transition period is highly

unlikely. In our view, the most likely outcome is that Mr. Johnson manages to achieve an FTA

by end-2020 (possibly serving as an interim arrangement to pave the way for a final FTA),

which includes transitional arrangements lasting at least 18 months (to give firms time to

adjust to the new set of rules). An FTA will likely do little to help UK-EU trade in services.

…irrespective of the election result

If, however, Mr. Johnson does not win a majority, the next UK government would likely seek

to hold a referendum on a negotiated Brexit deal versus remaining in the EU, subject to a

further extension of Article 50 being agreed with the EU to facilitate a referendum while the

UK is still an EU member. The European Council would likely (albeit reluctantly) extend

Article 50, presumably to end-2020. This would allow sufficient time to hold a referendum. An

extension beyond end-2020 would be very difficult politically because the new EU budget

starts on 1 January 2021. Should the UK vote to remain in the EU while still under the

Article 50 process, then the UK would remain in the EU on current terms.

Fiscal stimulus is on the way but not a game changer

Both of the UK’s main political parties (Conservatives and Labour) are promising significant

government-spending increases financed by additional borrowing. The Conservatives have

announced plans for net public investment to rise by around 1% of GDP over four years, and

Labour would more than double this rise. Using a fiscal multiplier for investment spending of

one (which the Office for Budget Responsibility uses), the Conservatives’ plans would add

around 1pp to GDP growth over four years. Both parties have pledged to run a balanced

current budget (i.e. excluding investment). While fiscal stimulus will boost growth, it is likely to

only cushion weakness generated from persistent Brexit uncertainties, weaker global growth

and the hit to productivity that is sure to result from a less open UK economy.

GDP and CPI forecasts We expect UK real GDP growth of 1.3% in 2019, 0.8% in 2020 and 0.9% in 2021. Headline

CPI inflation should ease to around 1.3% in 2Q20 in large part due to lower regulated utility

prices (which the MPC will look through) and ease a little further to 1.2% by end-2020 due to

the appreciation of sterling and weaker aggregate demand. Inflation is likely to recover with

demand in 2021.

BoE to cut the bank rate to zero in 2020

We expect the Bank of England’s monetary policy committee (MPC) to cut the bank rate by

25bp in 1Q20, 2Q20 and 3Q20 (taking the bank rate to zero) and to leave it there through

2021. At the MPC’s 7 November meeting, two MPC members, Jonathan Haskel and Michael

Saunders, voted for an immediate 25bp rate cut. In the past, the adjustment of interest rates

has often been preceded by a minority of MPC members dissenting at prior meetings, paving

the way for a policy move. The MPC minutes stated that policy could respond to changes in

the outlook in either direction: “If global growth failed to stabilise or if Brexit uncertainties

remained entrenched, monetary policy might need to reinforce the expected recovery in UK

GDP growth and inflation”… “[If, however,] these risks did not materialise and the economy

recovered broadly in line with the MPC’s latest projections, some modest tightening of policy,

at a gradual pace and to a limited extent, might be needed”. By “reinforce”, the BoE means

rate cuts, and although the MPC was careful to avoid getting dragged into election politics, it

is clear that the most likely scenario involves Brexit uncertainties becoming entrenched.




Sweden & Norway

Tightening cycle likely to have run its course

Chiara Silvestre Economist (UniCredit Bank, Milan) [email protected] Sweden: GDP growth is slowing

The recovery of the Swedish economy is holding back. After growing by 2.4% in 2018, GDP is

on track to expand by a modest 1.4% in 2019 and growth is forecast to stabilise in 2020. We

expect a small pickup to 1.7% in 2021. The growth prospects for 2020-21 reflect not only the

steep fall in housing investment, which is accounting for a large part of the easing in domestic

demand, but also the challenging external environment which has started to weigh on capex.

After a strong performance into 2019, which has mirrored the well-built competitive position of

Swedish exporting industries, exports are expected to slow significantly, due to lower growth

prospects for Sweden’s major trading partners. The cooling down of economic activity will

likely cause a deterioration of the labor market, with stagnating employment and rising

unemployment rate leading to weaker wage growth. In this environment, a slowdown of

private consumption appears likely.

The Riksbank is likely to pause at least until end-2021

The liftoff of the repo rate to zero in December is almost a deal done. After December, the

Riksbank forecasts a “prolonged period” of unchanged interest rates. In our view, the

challenging external environment, in combination with slower GDP expansion and inflation

rates averaging 1.5% in both 2020 and 2021 will lead the Riksbank to keep interest rates at

zero throughout the forecasting horizon.

Norway: GDP growth set to decelerate

Norway’s cyclical upturn is taking a break. After 2.5% in both 2018 and 2019, the growth rate

of mainland GDP is forecast to slow to 1.5% in 2020. Our GDP forecasts take into account,

externally, the deterioration in growth prospects of some of Norway’s main trading partners,

as well as our expectations of weakening in Brent prices. The latter is likely to lead to a

decline of strong growth rates of petroleum investment which has underpinned GDP growth

for most of 2019. This negative impulse will probably extend to the mainland economy, which

includes oil-related activities. Just as in Sweden, domestic risks to the outlook mainly stem

from the uncertainties in the housing market and the historically high level of household debt,

which makes households more vulnerable in the event that house prices fall steeply.

Norges Bank expected to stand pat through 2021

While lifting interest rates to 1.50% in September, the Norges Bank unveiled its plan to take a

break from the tightening cycle. In the wake of this announcement, as well as growing global

risks and their potential impact on the outlook for oil prices and the domestic economy, we

expect the Norges Bank to stand pat through the end of 2021.

GDP GROWTH SET TO LOSE STEAM AFTER DECEMBER, TIME TO PAUSE ALSO FOR RIKSBANK

Source: Norges Bank, Riksbank, Statistics Norway, Statistics Sweden, UniCredit Research

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2015 2016 2017 2018 2019 2020 2021

Sweden NorwayReal GDP (yoy, %)

Forecast

-1.50

-0.75

0.00

0.75

1.50

2.25

3.00

3.75

4.50

5.25

6.00

1Q04 3Q07 1Q11 3Q14 1Q18 3Q21

Repo rate (Sweden) Depo rate (Norway)

Forecast

%





Switzerland

Growth slowing but SNB steady



■ We expect the Swiss economy to grow 0.6% in 2020 and 0.7% in 2021 (2019: +0.8%).

The expectation for a slowdown in 2020 is mainly based on a weaker growth outlook for

Europe, which is Switzerland’s most important single trading partner.

■ Risks to our forecast are skewed to the upside, as additional revenue from royalties

associated with major international sporting events may boost GDP growth. This would be

similar to 2018, when additional revenue from royalties (such as World Cup and Olympic

Winter Games) led to a significant upward revision of growth data in 1H.

■ Exports have already lost considerable momentum in recent quarters. Muted global trade

and the cooling of the European economy will probably continue to dampen foreign

demand for Swiss goods in 2020. One stabilizing factor could be the pharmaceutical

sector, which has been benefiting from demographic changes abroad.

■ We expect overall investment activity to weaken further. Falling capacity utilization in the

manufacturing industry is likely to weigh on the capex spending of companies. In addition,

overcapacities and vacancies will persistently dent investment activity in the construction

sector in 2020 and 2021.

■ Inflation rates are likely to decline further in the next few quarters, since the weaker

economy will continue to dampen domestic price pressure. We expect consumer price

inflation to ease to only 0.1% yoy in 2020 from 0.4% yoy in 2019 (2021: +0.2%).

■ The SNB is likely to remain on hold in 2020 and 2021 with its key policy rate at -0.75%. In

order to soften possible upward pressure on the CHF, the SNB may additionally intervene

in FX markets. It is true that SNB President Thomas Jordan recently sounded (surprisingly)

dovish. He pointed out that the SNB stands ready to cut interest rates further into negative

territory. Furthermore, the SNB obtained moderate leeway to cut its key policy rate if

necessary. By not imposing charges on banks’ sight deposits as large as 25 times the

amount of minimum reserves (up from 20) in September, the effective interest charge on

banks was reduced to about -0.3% from -0.4%. However, we think that further interest rate

cuts by the SNB are only likely in the case of an emergency, i.e. a rapid and strong

deterioration in global (and/or European) economic activity followed by additional interest

rate cuts and an increase in the pace of bond purchases by the ECB.

GROWTH TO SLOW FURTHER ON GLOBAL SLOWDOWN SNB TO REMAIN ON HOLD

Source: Federal Statistical Office, Bloomberg, UniCredit Research

-4.5

-3.0

-1.5

0.0

1.5

3.0

4.5

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

1Q08 1Q10 1Q12 1Q14 1Q16 1Q18 1Q20

Real GDP (in % qoq) Real GDP (in % yoy, rs)

Forecast

-0.90

-0.80

-0.70

-0.60

-0.50

-0.40

-0.30

-0.20

-0.10

0.00

0.10

Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Jan-19

SNB policy rate, in % ECB deposit rate, in %






China

Trade uncertainty to weigh on growth


Roberto Mialich FX Strategist (UniCredit Bank, Milan) +392 88 62-0658 [email protected]

We expect China’s structural and cyclical slowdown to continue throughout our forecasting

horizon, with the GDP growth rate falling to 5.9% yoy in 2020 and to 5.7% in 2021 – outside the

6.0-6.5% growth range set by Beijing for this year. Signs of sluggish economic performance come

from multiple fronts. China’s exporters are taking the hit from the trade war with the US. Retail

sales eased again in 3Q19, dragged down by the slump in auto sales. Investment growth within

the private sector has decelerated sharply and state investment has offset it. The decline in

output PPI inflation has eroded the profitability of industrial corporates, restricting their ability to

invest. Also, the shifting of bank credit away from the private sector in favor of SOEs as a result of

both President Xi Jinping’s expansion of state power over the Chinese economy and the ongoing

growth deceleration is creating inefficiencies that might impair productivity going forward.

Trade war is the main downside risk

The trade war remains the main source of uncertainty over the next two years. The “Phase one”

trade deal, if finalized, is expected to bring some temporary relief in the months leading up to the

US presidential elections. And the additional pork imports from the US that Beijing is supposed

to commit to should reduce the inflationary pressures caused by the consumer price spikes

recently recorded as a result of the African swine fever. But trade tensions will likely resurface

once the two superpowers start to deal with stumbling blocks, such as technology transfer, SOE

subsidies and more generally “The Made in China 2025” industrial strategy. An intensification of

trade tensions would lead to a deterioration in sentiment, exports and investment.

More limited scope for stimulus measures

China has less policy space to stimulate the economy than in the past due to increasing

financial stability challenges. In the absence of a major economic shock, we do not see an

ambitious stimulus package in 2020 and expect major policy measures to be targeted and

selective. This could take the form of more monetary-policy easing by lowering the required-

reserve ratio for large banks (to 12% or lower by the end of 2019 from 13%) and cutting

benchmark lending rates for smaller banks. On the fiscal front, local governments will likely be

granted more flexibility in issuing special-purpose bonds to fund infrastructure projects.

USD-CNY back towards 6.90 in 2020, but 2021 may tell a different story

USD-CNY has corrected sharply downwards from the peaks above 7.18 hit in September

thanks to progress made in trade talks between Beijing and Washington. There have already

been attempts to drag the pair below 7.00 and we think that it is possible that further declines,

say towards 6.90, could occur in 2020. However, lower Chinese economic growth would make

the PBoC more prudent about allowing a more intense CNY appreciation, especially if, after the

finalization of “Phase one”, trade negotiations are frozen ahead of the US presidential election.

In this case, USD-CNY may well rebound back towards 7.10 in 2021.

THE STATE IS TAKING OVER PRIVATE INVESTMENT SHARPLY DOWN

Source: National Bureau of Statistics, UniCredit Research

0

25

50

75

100

2010 2011 2012 2013 2014 2015 2016

Flows of loans to NFCs by ownership (%)

Private State

0

10

20

30

40

50

60

Feb-05 Aug-06 Feb-08 Aug-09 Feb-11 Aug-12 Feb-14 Aug-15 Feb-17 Aug-18

Investment growth (yoy, %)

state private






Oil

Brent prices to remain weak


We expect Brent to average USD 57/bbl in both 2020 and 2021. However, these averages

hide a V-shaped rather than a flat path for oil prices. The price weakness is due to

fundamental factors, with supply remaining abundant and global demand slowing, whereas

the directionality reflects our macroeconomic outlook, with the US entering a technical

recession in late 2020 and then recovering some ground the following year.

Supply glut still the main issue Oil producers continue to pump more crude than the market can absorb. OECD commercial

inventories are stuck at around 2,900mn bbl – well above their pre-shale-boom average of

2,600mn bbl. Since US producers seem to have overcome many of the bottlenecks that might

have hindered production, we expect OPEC+ to adopt longer curbs at its December meeting,

extending them well into 2020. This might be enough to bring some short-lived market relief.

In reality, especially considering the scenario of a US recession, deeper cuts would be

required, but too many producers, Russia in particular, are opposing them. This is a risky

strategy, especially because a US-Iran diplomatic rapprochement concerning Teheran’s

nuclear program could bring back around 2mn Iranian barrels a day to the market, more than

offsetting the current OPEC+ cap of 1.2mb/d. Today’s curbs could only work if US producers

postponed investments in the face of low prices in order to remunerate their shareholders.

Demand not too concerning Demand weakness is less concerning than many market participants seem to believe. Growth in

oil demand is expected to show a decline from 2.1mb/d in 2018 to 0.8mb/d in 2019. Such a drop

would be in line with the development in oil demand recorded during other cyclical slowdowns,

such as those seen in 2002 and 2011-12. The current situation is very different from what

happened during the last financial crisis, when demand contracted by a cumulative 1.8mb/d

between 2008 and 2009. Moreover, a partial resolution of the trade tensions between the US

and China with the “Phase one” agreement, might stimulate demand somewhat and offset some

of the weakness caused by the US downturn.

Geopolitical risk in the background

The only factor that can really push prices high is sentiment, either because of a much-rosier

global growth outlook or as result of a geopolitical shock. When it comes to the latter, the

main source of risk is escalating tension in the Middle East between the two main regional

powers, Saudi Arabia and Iran. Skirmishes in the Strait of Hormuz have been going on for

many months. Equally, the drone attacks on some of Riyadh’s key oil infrastructure have

exposed unexpected vulnerabilities. However, given the oil-glut issue, only a major and

lasting geopolitical shock would be able to significantly impact prices.

V-SHAPED PATH FOR BRENT SLOWING DEMAND, BUT NOT COLLAPSING

Source: IEA, Bloomberg, UniCredit Research

30

40

50

60

70

80


Brent (USD/bbl)

Spot Futures UniCredit Forecast

-1.5

0

1.5

3

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Oil demand growth (mb/d)

Financial crisis

Cyclical slowdown Cyclical slowdown Cyclical slowdown





Cross Asset Strategy

Prefer fixed income as a US recession nears

Elia Lattuga Cross Asset Strategist (UniCredit Bank, London) +44 207 826-1642 [email protected]

■ 2020 asset performance will be a tug of war between monetary stimulus and deteriorating

growth prospects, at a time when most assets look rich compared with fundamentals.

■ We see a high probability of sharp drawdowns for risky assets as a US recession nears.

The Fed’s action will boost the return of USTs, but will fail to prevent large intra-year

corrections in global equities. Correlations will work their way to EUR assets, where non-

cyclical sectors should be preferred on both equities and credit. The quest for yield and

supportive flows speak for positive returns for credit, both on sovereign and corporates.

A spectacular and very correlated asset performance in 2019

Equities and bonds have delivered outstanding performances in the course of 2019, topping

the return of the last ten years for several assets. At the time of writing, the MSCI world is up

by over 20% YTD and returns are solid across countries, especially across developed

markets. Meanwhile, fixed income benchmarks returns are in the upper single digit, with some

credit exposure returning over 10%. Moreover, risk adjusted performance was very positive

(e.g. European credit returned over 3x their realized volatility). A similarly sharp equity rally

happened in 2017, when synchronized acceleration in GDP growth across the globe fueled

risky asset performance, while risk free asset returns were flat to slightly negative. 2019 has

not conformed to such script so far. Both risky and risk free assets delivered solid

performances, and the elevated cross asset correlation recalls QE driven rallies rather than

the typical risk-on environment. Indeed, the macroeconomic environment differed too. A

strong labor market, rising input costs and decreasing revenue growth, have been behind

dropping corporate bottom lines. Reported earnings for both the eurozone and US indices

poin to profit recession, and expectations for future earnings growth remain bleak. Meanwhile,

increasing leverage and large payouts to shareholders are amplifying risks to bondholders,

especially on US low rated corporates.

Still, sell-off episodes in risky assets have so far been short-lived in 2019. On the contrary,

equity indices marked new record highs (e.g. the S&P500) and further widened the gap

between macroeconomic (and corporate) fundamentals and assets valuations. The prospect

of a marked GDP growth slowdown, taking the US economy into a recession in, is set to

undermine such momentum. How long can easy monetary policy keep asset prices valuations

at current levels, against deteriorating growth? It is the key question for asset returns in 2020.

US growth is running on one engine alone – consumption. We believe that the petering out of

the fiscal stimulus will expose its fragility, pushing the US into a shallow recession in 2H20.

CHART 1: ASSETS PERFORMANCE AT A GLANCE CHART 2: EPS GROWTH AND VALUATIONS (S&P 500)

Source: Bloomberg, Refinitiv Datastream, UniCredit Research

-20%

-10%

0%

10%

20%

30%

40%

2019 (YTD) 2018 2017 2016

EU equities US equities EM equities

EGB core bonds UST bonds EU Credit IG

EU Credit HY EM HC bonds EM LC bonds

-20%

-10%

0%

10%

20%

30%

40%

8

10

12

14

16

18

20

Aug 10 Feb 12 Aug 13 Feb 15 Aug 16 Feb 18 Aug 19

PE (12M FWD EPS) 12M FWD EPS (rs)





A 20% drawdown on global equities

Timing the market reaction to such an event is difficult. However, given the high level of

valuations and the build-up of imbalances (e.g. VIX short positions have risen sharply on

CFTC data), we believe that the probability of a global equities drawdown in the 20% ballpark

ahead of the recession is high. The trigger might come from negative news on the consumer

side, denting growth prospects, or might be related to sentiment potentially accompanying

political developments or policy decisions. In this case, tightening financial conditions would

themselves be a driver of the growth slowdown. A recovery in global growth in 2021 would lay

the foundation of a recovery in appetite for risky-assets following the bearish turn we foresee.

The Fed has already delivered some precautionary cuts to extend the current economic cycle,

and more easing (more than what the market discounts) is likely to come as the slowdown

materializes. While it might be able to offset some of the losses and reduce the magnitude of

the drawdown compared to past recessions, the Fed will unlikely be able to halt cyclical forces

and defy gravity for long. Chart 3 shows that on average the downside of the S&P500 at times

of economic recessions has been just over 30%, since the1950’s, with the last two episodes

(2001 and 2008) showing above average losses.

Prefer long duration on USD denominated assets

Deteriorating risk appetite will be tailwind for the bond market, adding to the support offered

by rate cuts from the Fed. We see 10Y UST yields dropping as low as 1.50% by year-end,

with long duration adding up to over 5% total return over 2020. In the case of prior recession

periods (from the 1950’s onward), USTs have delivered returns of over 10% on average with

peaks at over three times such level, outperforming both cash, credit and equity exposure.

The starting government bond yield level is much lower this time, as yields have been on a

downward trend for over thirty years, but we expect a solid performance, especially in the

current market environment. Credit will benefit somewhat, but as one moves towards lower

rated paper, the sensitivity to the slowdown will increase while the support of the Fed will fade

out. The US credit cycle poses further risks, given the rising leverage, falling profits and rising

default rates. Therefore when it comes to USD denominated assets, we prefer the risk reward

offered by duration over credit exposure.

CHART 3: S&P 500 DRAWDOWNS IN PREVIOUS RECESSIONS* CHART 4: PERFORMANCE THROUGHTOUT THE RECESSION**

*The red line indicates the average for the considered episodes Source: NBER, Bloomberg, Refinitiv Datastream, UniCredit Research **US economic cycles since 1950

European equities, less risky than US peers but still exposed

Correlation will work its way into European assets, also exposing European equities to losses.

Domestic developments are not supportive of an equity bull story either. We see eurozone

growth deteriorating throughout 2020 as global headwinds continue. Further, while ECB’s

September package will preserve ample monetary accommodation, the bar for sizeable

incremental stimulus is high. Cheaper valuations compared with US equities and a higher

equity premium (consequence of lower yields across Europe) remain supportive factors for

European equities, at least in relative terms, and create the potential for further positive

momentum in a positive risk scenario where global growth recovers. However, all these

variables considered, we recommend a defensive allocation for European equities and prefer

sectors such as Food & Beverage, Health Care, Personal & Household Goods and Utilities.

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2007 1973 2001 1969 1981 1990 1957 1953 1960

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S&P 500 10Y UST Baa Credit 3M Tbill Comm

Average Last 3 episodes




Credit exposure to be preferred for EUR denominated assets

ECB’s flows will continue to support the assets targeted by the asset purchase program (APP).

However, we believe that Bunds are close to their fair value and long duration in EUR and will

deliver muted returns. Thanks to ECB’s flows and featuring the scarce attribute of a yield pick-

up, government bonds across periphery offer better potential. Similarly, we believe that

corporate credit will attract solid demand thanks to the hunt for yield and its positive technical

picture (CSPP and lower expected supply). Some caution is warranted: exposure to the global

cycle and/or to negative credit rating dynamics needs careful consideration when picking across

ratings and sectors, especially across high yield. We think that European companies remain less

vulnerable to credit concerns compared with their US peers but spread dispersion will continue

across the rating spectrum, with the lowest rated segments more exposed to losses. Hence, we

project solid returns from EUR high yield (over 3%) mainly coming from carry but spreads will

likely widen as well. Just as with equities, we prefer less cyclical sectors.

CHART 5: MIND THE CORRELATION (YOY RETURNS) CHART 6: RELATIVE VALUATIONS IN EU

Source: Bloomberg, Refinitiv Datastream, UniCredit Research

ECB’s flows might trigger more portfolio reallocation on domestic assets than during APP 1

ECB’s measures might turn out to be more supportive than in the past for EUR denominated

assets, particularly credit (sovereign and corporate). Indeed, asset purchases during 2015-17

fueled large outflows of funds from the eurozone, as the proceeds of bond sales to the ECB (by

residents) were mostly reinvested in foreign assets. Little portfolio reallocation into other EUR

denominated assets (being it credit or equities) happened. Balance of payment data suggests

that in that period, US government bonds along with Gilts and JGBs attracted strong interest by

eurozone investors. Judging from the targeted investments, yield enhancement and liquidity

considerations may have driven such outflows. At that time, USTs offered an attractive pick-up

on Bunds (over 50bp), even after hedging for the currency risk. This situation is no longer the

case. The cost of hedging EUR-USD exposure over a 3M horizon (via FX swaps) is nearly 2.5%

annualized, making UST yielding less than Bunds (e.g. on a 10Y maturity) once FX risk is

covered. In this respect, investing in foreign bonds might be less attractive than during the first

APP. Additionally a larger share of the reinvestments might be reallocated towards EUR

denominated assets. Whether equities will benefit from such flows hinges on the growth outlook.

A growth re-acceleration in 2021 would improve prospects for both equities and high yield and

make them attractive following the cheapening induced by the approaching US recession.

Deteriorating risk appetite but no sizable fund repatriation

Risk aversion will likely prevail in global markets during the US slowdown. However, a shallow

US recession and supportive monetary policy should help avoid a meltdown in risky asset

performance. In this area, we do not envisage sizable and prolonged repatriation of funds in the

US. Consequently we believe that EM bonds – especially hard currency denominated ones –

will continue to attract investors seeking a yield pick-up. As the US credit cycle remains a threat,

we believe that the EMEA region offers the best risk reward. Similarly, while risk aversion will be

tailwind to risk haven currencies, we do not see the US dollar gaining much strength. The extent

of monetary policy synchronization should limit the extent of swings in FX majors. Moreover,

both the growth and rate differential between the US and the eurozone are expected to narrow,

creating the case for a moderately higher EUR-USD over the forecast horizon.

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S&P500 EU HY US HY

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Nov 10 May 12 Nov 13 May 15 Nov 16 May 18 Nov 19

E/P STOXX Europe 600 Bund yield IG ytw HY ytw




FI Strategy

UST yields to decline on Fed’s action and growth slowdown

Dr. Luca Cazzulani Deputy Head of FI Strategy (UniCredit Bank, Milan) +39 02 8862-0640 [email protected] Chiara Cremonesi FI Strategy (UniCredit Bank, London) +44 207 826-1771 [email protected] Michael Rottmann Head of FI Strategy (UniCredit Bank, Munich) +49 89 378-15121 [email protected]

■ We expect UST yields to fall throughout 2020 due to a downturn in the US and the Fed

delivering four rate cuts. We see the 2Y UST yield ending the year at 1% and 10Y at

1.50% with the 2/10Y spread bull steepening.

■ Deteriorating growth and inflation outlook and an accommodative ECB will keep the 2Y

German yield trading sideways, while they are likely to trigger a moderate decline in the

10Y Bund yield to -0.50% by the end of 2020.

■ BTPs will again be caught between appetite for carry, weakness in fundamentals and

domestic politics. We see the 10Y BTP/Bund spread ending the year at 150bp.

■ We recommend overweighing duration in USTs next year. In the euro area, negative Bund

yields require either a very bold duration extension or credit spread exposure.

■ Risk to our forecast is asymmetrically skewed towards higher yields in Bunds while is more

balanced in USTs.

An amazing year for bonds on both sides of the Atlantic

The end of 2018 and 2019 saw a turnaround in market sentiment that deeply affected the

rates universe. We started the year with most analysts predicting further rate hikes by the Fed

and the ECB normalizing the depo rate to 0%, and we are ending the year with central banks

having turned dovish, with both the Fed and the ECB cutting rates and the ECB resuming QE.

The reason behind the change in the central banks’ stance on both sides of the Atlantic (first

the Fed and then, with a sizeable lag, the ECB) has to do with global trade and global growth

slowing down, subdued inflation and inflation expectations and, most importantly, global

uncertainty rising to unprecedented levels. As a result, 2019 was also the year when bonds

delivered impressive returns, as yields declined sizably across the board: USTs

(all maturities) delivered a 7.3% total return YTD, Bunds 4.3%.

CHART 1: UCG FORECASTS VS. FORWARDS

CHART 2: US CURVE EXPECTATIONS VS PAST EASING CYCLES*

*The chart shows the change in bp occurred between the beginning and the end of Fed easing cycles. We computed the average during easing cycles with a recession and insurance cut cycles starting from 1989. Insurance cut cycles are: Jul1995-Feb1996, Aug1998-Dec1998. Easing cycles including a recession are May1989- October 1992, Dec2000-Jul2003, Sep2007-Jan2009. Source: Bloomberg, UniCredit Research

More specifically, in the US, 2019 saw a combination of downward revisions to monetary

policy expectations and a compression of the term premium that led to a sharp decline in UST

yields, of around 90bp for the 2Y (from 2.50% to 1.60%) and about the same for the 10Y

(from 2.65% to around 1.75%).

1.00%

1.50%

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2.50%

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1.00%

1.50%

2.00%

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Dec-17 Dec-18 Dec-19 Dec-20 Dec-21

2Y UST yield 10Y UST yield

2Y forecasts 10Y forecasts

2Y forwards 10Y forwards

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fed fund change 10Y-FF change 2-10Y change 2Y-FF change

Easing cycles with recession

Insurance cut cycles

Our expectations for this cycle

bp







We expect 2020 to be another year of declining yields

We expect 2020 to be another year of declining UST yields, with the 2Y ending at 1% and the

10Y at 1.50%. The 2/10Y UST spread should continue steepening (although quite moderately

compared to previous easing cycles) reaching 50bp area. US growth slowdown, with the

economy experiencing a moderate recession in 3Q and 4Q, subdued inflation and inflation

expectations, a much more dovish Fed’s call compared to what is priced in by markets and global

uncertainty remaining elevated are the main reasons supporting our bullish call for US rates.

The Fed’s monetary policy and its impact on UST yields and the UST curve

We expect the Fed to deliver four rate cuts, one each quarter, with the fed funds rate ending

2020 at 0.50-0.75%. This is a much more aggressive view than the market, which is currently

discounting only one to two rate cuts by the end of 2020. Hence, our view on UST yields is

much more dovish than the forwards suggest (Chart 1).

So far, the Fed has been delivering an insurance cut cycle cutting the fed funds rate by 75bp

in the last four months. Next year, we expect the Fed to move from an insurance cycle to full-

fledged easing15

due to a continuing slowdown in the economy. We expect a total of 175bp

easing during this cycle.

Compared to the last “proper” easing cycles that included a recession, the total amount of

cuts delivered by the Fed is likely to be much lower this time, which in our view should

translate into a much more moderate steepening of the UST curve compared to previous

easing cycles (Chart 2).

In this respect, we expect the 2Y/fed fund spread to end 2020 at 25bp, less steep than on average

in the previous “proper” easing cycles, when the end point of this spread was on average 50bp.

CHART 3: TERM PREMIUM HAS BEEN FALLING AT THE START OF THE CURRENT EASING CYCLE

CHART 4: UCG FAIR VALUE MODEL FOR 10Y REAL UST YIELDS

Trade: trade uncertainty index QE: Fed’s holdings of USTs as % of US marketable debt F: Foreign holdings of USTs as % of US marketable debt Y*: potential growth by CBO

Source: Bloomberg, UniCredit Research

Moreover, during the past easing cycles, the 10Y UST (nominal) term premium started

increasing as the Fed delivered the rate cuts, signaling that investors expected interest rate

volatility as well as inflation volatility to pick-up in the future. In this cycle, we did not observe this

dynamic; the term premium actually declined once the Fed started cutting rates (Chart 3).

We think that this is related to global political uncertainty and trade-related uncertainty, as well as

subdued inflation expectations; as we expect uncertainty to remain at elevated levels next year,

and inflation expectations to remain subdued, we took into account this factor in our forecasts. 15

We use the following convention: we call insurance cycles the Fed’s easing cycle in which the economy did not go into recession and that are shorter in length, while

we call “proper” easing cycles the ones which included a recession. Starting from 1989, we consider insurance cycles the one in July 1995-February 1996 and the one in

August 1998-December 1998. We consider “proper” easing cycle the ones in May 1989- October 1992, December 2000-July 2003 and September 2007-January 200916

https://www.policyuncertainty.com/wui_quarterly.html

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1995 1998 2001 2004 2007 2010 2013 2016 2019

Fed funds mid (ls)

10Y UST term premium (ACM, bp, rs)

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1997 2000 2003 2006 2009 2012 2015 2018

10Y real UST yield

Model fit without trade (QE, F, Y*)

Model fit with trade (trade, QE, F, Y*)





Global uncertainty is playing a major role in compressing long-term real UST yields

Another way of predicting the performance of the 10Y UST yield next year is by looking at the

real yield and inflation expectations going forward.

Our quarterly model of the fair value of 10Y UST real yields, which is based on US potential

growth, as well as holdings of USTs by foreign investors and by the Fed, both expressed as a

percentage of US federal marketable debt, shows that 10Y UST real yields should be some

135bp higher than they are now. The fit of our model started diverging from the actual value in

September 2018, around the time that uncertainty linked to trade started increasing.

Once we include an indicator related to trade uncertainty in our model (we use the World

Trade Uncertainty Index compiled by Ahir, Bloom and Furceri and available on Bloomberg16

),

the residual practically vanishes. In a nutshell, the indication we get is that trade uncertainty is

currently playing a major role in compressing long-term UST real yields (Chart 4).

We expect 10Y real UST yields to edge down further next year

In this respect, next year will not be the year when 10Y UST real yields converge to the fair

value predicted by our non-augmented model (the one without the trade uncertainty variable):

first, we expect the fair value of our non-augmented model to decline (although moderately)

and second, we expect the level of trade-related uncertainty to remain high.

Potential growth is the variable in our model most likely to trigger a (moderate) decline in fair

value. In its current estimates, the CBO predicts potential growth will decline in the US in the

next two years and this could even become more pronounced next year. The other two

variables will probably be mostly neutral. Foreign flows into USTs will probably be smaller

than this year17

and the Fed’s holdings of USTs will likely increase, although the increase will

probably concentrate on T-bills, which will provide less support than outright buying of USTs.

All in all, this indicates that UST real yields have room to decline further from the current 0.10-

0.15% and to slide towards 0% over the course of next year.

Inflation expectations to remain very subdued

Inflation expectations in the US are currently subdued, with 10Y US breakeven rates trading

in the 1.60-1.65% area. According to our quarterly model based on the output gap and PCE

core inflation (the Fed’s favorite inflation gauge), breakeven inflation rates should be around

35-40bp higher than they are now. That said, with growth slowing and the output gap opening

up again, we see little room for core inflation to rise. This paints a picture of declining inflation

expectations. Declining, oil prices will also add another reason for inflation expectations to

decrease. We expect 10Y breakeven rates to re-test the 1.50% lows during 2020.

Putting together our view for real yields and inflation expectations, we expect to end the year

with 10Y nominal UST yields at 1.50%. Note that 1.50% is a very important support level and

it is very near the historical low. We do not think that this level will be broken to the downside,

but our call still sees 10Y USTs reaching it.

Last but not least, in the first part of the year, we see high probability of a drawdown in the

range of 20% for global equities, in anticipation of the technical recession. This factor should

provide some extra-support to USTs, at least at the start of the year.

16

https://www.policyuncertainty.com/wui_quarterly.html 17

TICs flows show that from January 2019 until September 2019, there have been record flows of foreign investment into USTs, with more than USD 500bn of

inflows. The increase was widespread, with Japan and the eurozone being the main contributors, but Taiwan, Hong Kong, Singapore, Thailand, India, UK, Canada, Saudi Arabia and Norway also active. We note that this has happened with foreign official investors increasing their exposure to USTs, likely as a consequence of the increase in central-bank reserves.





A quick glance at 2021 in the US

In 2021, we expect the US economy to recover and global trade to enjoy a brighter outlook

compared to 2020. This means that very gradually we expect long-term real UST yields to

come back towards their long-term equilibrium. With inflation expectations also gradually on

the rise, we have a target of 2.50% for the 10Y UST yield at the end of 2021. We also see the

2Y yield increasing, although much more moderately, as this tenor is not as significantly

impacted directly by global uncertainty, and the growth recovery will likely be moderate. This

means that we expect the 2/10Y UST spread to widen further to 120bp by the end of 2021, a

much more aggressive call than that implied by the forwards.

Bunds: no respite from negative yields

10Y Bund yields have dropped 50bp in 2019, sinking below 0%

EGBs have had a very good year, supported by slowing growth momentum, accommodative

ECB monetary policy and political uncertainty (Brexit and trade war). The 10Y Bund yield

moved from 0.20% to -0.70% in August, before rising back towards -0.30%. The low-yield

environment has favored yield hunting, driving cross-country spreads tighter. In this context,

Italy significantly outperformed other EGBs, reflecting an improving domestic political picture.

Core EGBs require a short-term, trading oriented attitude: expect episodes of volatility

Core yields are set to enter 2020 at very low (if not negative) levels, with yield curves

extremely flat. Term premium has been declining in recent years and we estimate it to be

negative. With carry absent or negative, buying core EGBs requires a bias for yields to go

even lower. Furthermore, investors are likely to be quick to take profit as soon as positive

momentum loses steam. Put differently, market is likely to be dominated by investors with a

short-term approach and this is likely to lead to higher volatility.

Key reasons why we expect core yields to stay low: Moderating growth… …weak inflation…

We see the following key reasons for Bund yields to decline in 2020: deteriorating global

growth and inflation outlook, easy monetary policy (including QE) and deteriorating risk

appetite.

We expect the growth outlook to deteriorate in the second part of 2020, with the slowdown

originating in the US and affecting the eurozone. This also should support demand for fixed-

income assets because of the expected central bank action.

At the same time (and related) we project inflation to remain sluggish (core around 1.1/1.2%

in 2020 and in 2021). We also expect oil prices to decline during 2020. Hence, while

breakeven inflation in the eurozone appear to be about 30bp undervalued relative to our fair

value model, a meaningful increase next year is unlikely.

CHART 5: UCG BUND YIELD FORECASTS IN ONE CHART

CHART 6: UCG MODEL FOR GERMAN REAL YIELDS POINTS SOUTH


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Dec-17 Dec-18 Dec-19 Dec-20 Dec-21

2Y Bund yield 10Y Bund yield

2Y forecasts 10Y forecasts

2Y forwards 10Y forwards

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2001 2003 2005 2007 2009 2011 2013 2015 2017 2019

Residual (RS) Actual Fit




…the ECB policy stance… …with QE keeping scarcity going… …correlation with other markets… …and portfolio reallocation.

In a context of subdued inflation and deteriorating growth outlook, the ECB is indeed likely to

maintain an accommodative policy stance and, if anything, may come under pressure to

deliver further easing to match at least in part the bold action we expect by the Fed. The less

controversial measure in this case would be to cut rates further. Lower funding rates would

put downward pressure on yields, especially at the short and medium maturities.

In addition, the ECB will run QE in 2020. We expect purchases of public securities to be EUR

125bn in nominal terms, which roughly matches the entire euro area net issuance. As in the

past, in some jurisdictions QE purchases will exceed net issuance. In particular, for Germany

we calculate that QE purchases will exceed net issuance by roughly EUR 30bn. In this

respect, scarcity will continue to intensify over the course of next year, providing ongoing

support to Bunds – amplifying yield drops and cushioning the rise in the event of a sell-off.

In relation to Fed easing, we expect US yields to be falling during 2020. Since the start of the

EMU, the correlation of 10Y US and Bund yields has ranged from 50% to 90%. This is

another factor that should exert downward pressure on Bund yields.

Furthermore, with slowing growth in the US we expect a period of significant correction in

equity markets. When, such episodes occur, investors tend to turn to EGBs. Indeed, equities

and bond returns are negatively correlated, especially during sell-off episodes. For example,

the S&P dropped 20% between October and late December 2018, during the same period,

10Y UST yields dropped by 45bp.

According to our model for German 10Y real yields, if we consider QE next year as well as

some moderation in growth momentum, the fair value is likely to decline towards -1.50%.

CHART 7: SCHATZ TO REMAIN CAPPED BY ECB FUNDING CHART 8: ASSESSING THE BTP BUND SPREAD*

*Numbers indicate debt/GDP and growth, including our forecasts. Black line is the average since the start of QE excluding periods of severe political uncertainty. Dotted lines represent the range in the same period. Source: Bloomberg, UniCredit Research

Our forecasts for Bund yields: 10Y to reach -0.5% at the end of 2020 2Y broadly sideways

Against the backdrop of our economic scenario, we expect 10Y Bund yields to drop toward

-0.50% in late 2020, a period when downward pressure originating from the US will be

particularly intense. A long lasting move below this target would require expectations of lower

ECB rates. As soon as the economic picture improves in early 2021, we expect yields to drift

higher with the 10Y turning positive at the end of the forecasting horizon.

2Y Bund yields are likely to trade mostly sideways in 2020. With the ECB not delivering

further easing, repo rates stabilizing at or slightly below the deposit rate and ongoing scarcity

as a result of QE, room for directionality is limited.

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Jan-15 Jan-16 Jan-17 Jan-18 Jan-19 Jan-20 Jan-21 Jan-22

ECB depo rate 2Y Bund yield

UCG depo rate fcst. UCG 2Y forecast

Rate cut expectations,trade tension & Brexit

French elections& QE pressure

135.3 134.8 134.1 134.8 136.2 136.7

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Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19 Dec-20

10Y IT-GE yield spread

10Y IT-SP yield spread




Yield hunting to favor curve flattening, especially at the extra-long end

With yields constrained in relatively narrow ranges, there is not much room for the curve

shape to change. If anything, we have a bias for a moderate bull flattening in the 2/10Y area.

With core yields negative and a generally positive environment for bonds, we expect investors

to roll up along the curve, leading to a flatter 10/30Y. A significant flattening of the German

10/30Y spread from current levels would require 30Y yields to turn negative. While we have

seen this occurring this year, it’s safer to set up this trade with curves where the 10/30Y

spread has room to tighten without the need for negative 30Y yields.

Money market rates: excess liquidity is still king

Money market rates are expected to closely track the ECB deposit rate. With excess liquidity

bound to stay abundant next year, the newly created overnight rate (€STR) should trade

below the ECB deposit rate. The jury is still out as to the effect of tiering – main issue being

an uneven distribution of excess liquidity across jurisdictions and an unknown degree of

market fragmentation – however €STR price dynamics have been constructive so far.

Tensions on MM rates related to tiering (if any) are likely to be relatively limited considering

that there would be no reason to borrow at rates higher than 0%. Significant shocks to €STR

would require a sharp deterioration in risk appetite or in excess liquidity (the latter not on the

table given QE). Finally, tensions on MM rates, especially €STR and Euribor can be

counteracted by the ECB adjusting the parameters. With the ECB not expected to move the

depo in our central scenario, the 3M Euribor should trade sideways. Given the Euribor stands

good chance of remaining in place after the end of 2021, we do not envisage any pressure

towards the end of the forecast horizon.

We expect Bund/swap spreads to remain stable

2Y Bund-swap spreads have cheapened to less than 30bp this year and are back at their

2014/15 levels. The German short end is a good indicator of risk aversion as swap spreads

widen during episodes of tension. While it would be tempting to use the cheap entry level to

set up hedges against deterioration in risk appetite, carry from this position is highly negative.

Unlike 2Y Bund swap spreads, 10Y Bund-swap spreads are still richer than they were in

2014/15, which reflects the Bunds’ relative scarcity. We see two factors at work in 2020: QE

will keep longer tenors scarce while negative yields should create an incentive for investors to

set up receiving positions. The latter should prevail, driving 10Y Bund swap a bit cheaper.

BTP-Bund: go for the carry but beware of political risk

BTP credit spreads have tightened significantly this year, reflecting the improving political

situation in Italy. The 10Y spread has moved from 250bp at the start of the year to around

155bp and the 2Y spread has tightened 50bp, from 100bp to around 65bp. The 2/10Y yield

spread has tightened accordingly but remains considerably steeper than on the other EGB

curves. In a world of negative yields and high excess liquidity, the still relatively high credit

spread offered by BTPs will be hard to overlook, particularly early in the year when portfolios

and strategies for the year are being set up. QE will provide additional support to BTPs,

buying an estimated two-thirds of net issuance. We therefore expect the BTP-Bund spread to

tighten toward 125bp in early 2020.

Economic fundamentals are likely to be a moderate drag in the medium term: growth is

expected to remain low and below the eurozone average, while debt/GDP is expected to rise

to around 137%. Deteriorating risk appetite related to the slowdown in the US is also likely to

weigh on BTPs later in 2020, pushing the spread back towards 150bp.

Domestic political developments will remain a wildcard throughout the year. While not our

central scenario, a government crisis followed by early elections would lead to significant

spread widening, with the 200/250bp area as a target.




Portfolio recommendation: overweigh duration in USTs, be more cautious with Bunds

Adding it all up: duration prescription

In this section we calculate expected returns from government bonds in 2020 and 2021 and

provide portfolio recommendations.

Our prescription for USTs in 2020 is clear: overweigh duration as we expect returns to be

positive with price performance and carry working in the same direction. The expected return

from 10Y USTs is in the 5.0% area while 30Y USTs are expected to deliver even higher

returns. Expected returns at both the 2Y and the 10Y, would remain positive even if yields

turn out to be 50bp higher than our forecast.

In 2021 our forecasts require to underweight duration; we expect sharply negative returns

from 10Y USTs, while 2Y USTs should still provide a positive return. Both in 2020 and in

2021, we would also recommend steepening bias in UST portfolios.

Positioning is trickier in the eurozone. Returns from Bunds are likely to be negative at the

short end and slightly positive at the 10Y, although it will not take much to turn them negative

(for example if Bund yields are 50bp above our forecasts, returns would be negative to the

tune of -3%).

Two prescriptions emerge from our forecasts with respect to the euro area: extend duration

beyond the 10Y (a 30bp decline in 30Y yields will work wonders) and/or take credit exposure

(for example buying BTPs).

From the perspective of a EUR based investor, it should be considered that cost of hedging

the USD currency risk via FX forwards runs at around 2.5% for one year. This would erode a

sizable fraction of our expected performance at the 10Y but still leave a positive return, while

would leave expected returns from 2Y USTs at 0%. Taking an un-hedged position in USTs is

not advisable given we expect the EUR-USD to rise to 1.16 by end 2020.

CHART 9: STAY LONG DURATION IN 2020, ESPECIALLY IN THE US

CHART 10: EXPECTED BOND RETURNS: A HISTORICAL PERSPECTIVE*

*returns of Bloomberg-Barclays 7-10Y indices. US in USD Source: Bloomberg, UniCredit Research

-8%

-6%

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0%

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4%

6%

2Y 10Y 2Y 10Y 10Y

US Bund IT

2020 2021expected returns

-5%

0%

5%

10%

15%

20%

2014 2015 2016 2017 2018 2019f 2020e

IT GE USreturns*




Risk symmetry skewed towards higher Bund yields whereas it is more balanced for USTs

Not only are our rates forecasts well below forwards and consensus forecasts but we predict

limited swings throughout 2020 based on our quarterly forecasts given our subdued growth and

inflation outlook. In contrast, this year’s range for 10Y Bund and UST yields was the widest in

several years. The Bund range has covered 99bp so far, the widest since 2015. In USTs, this

year’s trading range of 133bp is almost three times the average of the past four years. At the

same time, 2020 is rich with unknown knowns, which may lead to stronger directional

momentum than covered by our forecast.

The following risk assessment is not a numeration of various isolated up and downside risks and

we leave aside event risks, such as the US and UK election outcomes and the unlikely case of

strong fiscal stimulus in Germany or a significant move forward in the architecture of the euro

area. While these appealing topics might be highly price-sensitive, they are more appropriate for

a “Ten surprises for 2020”-style publication.

In our view, the risk to our forecast is asymmetrical and skewed towards higher yields in Bunds

but more balanced in USTs.

Risk symmetry in Bunds tilted to the upside…

Discussing the risk symmetry in bond markets, monetary policy aspects come to mind in

Bunds: We see the risk tilted towards higher yields compared to our forecast of 10Y Bunds

being close to -0.5% at YE20.

While no-one knows for sure the exact level of the reversal rate in the euro area, we suspect

that it is not substantially below the current level. Under the assumption that the Bund curve

will not invert at a lower level, this points to the likelihood that the risk is asymmetrical and

tilted to the upside, compared to our forecast for 10Y Bunds. A further argument comes from

the discussion of the ECB monetary policy strategy review. A fully symmetric inflation target of

(or just below) 2% would not be much of a game-changer, in our view, as long as it is not

combined with an average-inflation or price-level targeting approach. With bygones being

bygones and even the current "below, but close to, 2% over the medium term" has not been

achieved over the past years, it is hard to see how a minor change to a symmetric 2% target

is likely to help lift market-based inflation measures higher from the current 1.10%, according

to the EUR zero coupon inflation swap and 1.25% in 5Y5Y forward inflation. A change to an

inflation range of 1.5% to 2.5% would be quite different. Despite market participants possibly

focusing on the lower end of the band, it would most likely reduce speculation about

aggressive monetary accommodation going forward. Even with the macro risk of escalating

trade tensions arising, we find it hard to imagine our -0.5% forecast for 10Y Bunds being

undershot by more than around 30bp.

If there is a significant improvement in global tariff tensions, the door appears open for 10Y

Bunds to return towards the average and midpoint from 2018 at around 0.5%. Tariff reductions

fuel global business sentiment and might encourage speculation that the ECB might reverse at

least the last cut in the deposit rate already in 2021. Further, based on the sequencing of

forward guidance (“… (APP) to end shortly before we start raising the key ECB interest rates”),

this dynamic could also heighten speculation about an end to the current APP program. The

scarcity effect working via a lower term premium would therefore only get smaller and the

expected average risk-free rate would rise modestly.




…but is more balanced in the US, although current levels are exceptionally rich

In the US, the risk symmetry is more balanced as the reversal rate is nowhere near current

levels, even under our subdued baseline scenario. In a worst case scenario where trade

friction escalates and leads to higher tariff rates, key rates may go down all the way to zero

and unconventional tools would again be a reliable option. In our view, prior lows in 10Y USTs

around 1.3% (hit in 2012 and 2016) are not a reasonable floor. Under such circumstances,

the 10Y UST yield could fall into a 0.5-1.0% range, in our view.

In contrast, the 10Y UST yield might return to 2.6%, a level they traded before average tariffs

between China and the US ramped up and measures against Huawei added a technology-

war component to the trade friction.

Compared to our forecast at 1.5%, the risk skew for USTs is much more balanced than our

risk assessment for Bunds.

Additional support in favor of higher yields may arise later in the course of 1H20, when the

outcome of the Fed policy strategy review is announced. We assume the Fed will refrain from

yield-curve control, but introduce an average-inflation approach. Market-based inflation

compensation is likely to move closer to 2% under such a mandate, becoming better

anchored in the future with bygones no longer bygones. In theory, an average-inflation

approach also means that when inflation undershoots, key rates remain lower compared to

the current approach, which might also keep real rates lower. That said, we doubt that, this

will overcompensate the effect from higher break-even inflation rates for longer maturities.




FX Strategy

The absence of major FX trends is likely to continue

Roberto Mialich FX Strategist (UniCredit Bank, Milan) +392 88 62-0658 [email protected]

■ Ample liquidity conditions and still quite synchronized economic cycles worldwide are more

likely to favor range trading than major trends over the coming quarters. However, more

Fed easing with the ECB on hold is likely to offer EUR-USD some upside potential.

■ GBP is set to benefit from a Brexit deal, but the risk of a “cliff-edge” in December 2020 and

BoE easing will likely slow its recovery. Due to lingering risks worldwide, the JPY is likely to

stay firm even if the BoJ moves to steepen the Japanese yield curve. Persisting trade

tensions between US and China will likely limit the downside potential for USD-CNY.

Is volatility dead? Then, long live volatility!

The main surprise in FX markets this year has undoubtedly been the very low level of

volatility, both implied and realized. The anomaly here is that the various sources of risk

worldwide, particularly the trade row between the US and China and Brexit, should have led

to much higher volatility. Nevertheless, FX majors remained confined within tight trading

ranges for most of the year with investors finding difficulty in riding even minor trends.

The volatility puzzle: the role played by central banks…

Why has this happened and, more critically, can it continue? We think that an important factor

behind the modest FX moves has been the provision of ample liquidity by central banks in

their ultra-loose monetary policy accommodation strategies.

…and the risk that the phenomenon may be self-fulfilling…

Chart 1 plots the aggregate of the balance sheets of the G4 central banks (Fed, ECB, BoE

and BoJ) since 2008 against the simple average 3M implied volatility of EUR-USD, USD-JPY

and GBP-USD. Ample available liquidity dragged interest rates into negative territory and a

lower propensity to take currency risks by investors due to global uncertainty reduced the hunt

for protection and thus demand for volatility. This phenomenon tends to become self-fulfilling:

low realized volatility calls for low implied volatility through short gamma strategies and low

volatility hints that currencies will likely stay stuck within tight bands, which does not provide

an incentive for investors to pay extra hedging costs, even if such strategies are cheap.

...in a world economy that is still very synchronized…

In addition, economic cycles remain largely synchronized worldwide, with most regions

experiencing tame inflation pressure and sluggish growth amid expectations of a further

deceleration of both of them. Consequently, monetary policies worldwide tend to be similar,

accommodative and synchronized. This also explains why major trends have failed to

materialize in FX markets this year, while they have been more evident in other asset classes,

like equities and bonds.

CHART 1: CENTRAL BANK LIQUIDITY FLOOD LIKELY PLAYED A KEY ROLE IN REDUCING FX VOLATILITY

CHART 2: BENEFITS FROM A US SLOWDOWN? NOT A ONE-WAY STREET TO THE UPSIDE FOR EUR-USD


5

10

15

20

25

10

15

20

25

30

35

40

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

G4 central banks' balance sheet as % of GDP

Implied volatility index for G4 FX Majors (rs)

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

-6

-3

0

3

6

9

12

15

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019

US GDP EMU GDP EUR-USD (rs)





…with more monetary policy accommodation ahead

Still, major central banks are unlikely to reduce their balance sheets over the course of our 2Y

forecast horizon with some becoming even more expansionary, if anything. This is certainly

the case for the Fed and the BoE and most likely for the BoJ, while the ECB has already

announced a new round of QE. Therefore, there appears to be a material risk that FX majors

will remain stuck within tight trading ranges over the coming quarters. Without significant

shocks, breaking the stalemate and restoring major trends may not be easy.

USD: a US slowdown and more Fed easing are bad news

We envisage a much clearer economic slowdown in the US in 2020. The Fed is therefore

likely to be forced to deliver an additional 100bp of easing next year, dragging the upper

bound of the fed funds range rate down to 0.75%, while monetary policy will likely stay on

hold in 2021. This is bolder action than that currently priced in by the US forward curve, which

implies the fed funds effective rate will only drop to 1.50% over a two-year horizon. At the

same time, eurozone GDP growth is likely to remain sluggish, but in the absence of a German

recession and with the ECB expected to remain on hold.

EUR: Still no great upside potential ahead…

The scenario we outline would normally suggest a much higher EUR-USD, but we do not

think that the pair has a huge upside potential. Chart 2 shows that since the launch of the

euro in January 1999, a US slowdown has not necessarily been associated with a strong rise

in EUR-USD, as the move also depends on the economic conditions and prospects of the

eurozone. Still, EUR-USD benefits when growth differentials between US and the eurozone

shrink as we expect in our scenario, but the process might not be very linear. For instance,

Chart 3, which plots EUR-USD against the German Ifo survey and the ISM manufacturing

index (both set equal to 100 in January 2019), shows that for most of the year the worsening

business climate in Germany has dragged EUR-USD lower, even in the face of a slightly

more intense deterioration of business expectations in the US. This was probably because the

manufacturing sector is more relevant for the eurozone than for US growth. Only when the

ISM PMI broke below 50 in September, did EUR-USD receive a (minor) lift, suggesting that a

significant deterioration in the ISM manufacturing index is needed to trigger a USD sell-off.

…but a recovery back to 1.16 by end 2020…

We therefore anticipate just a moderate EUR-USD rise back to 1.16 by 4Q20, a level that

leaves the pair in line with our estimation of its fair value of 1.15 (see the appendix at the end

of this section). The EUR-USD appreciation we expect (5.5% from the current spot rate at

1.10 in 1Y time) would not be dramatic enough to alarm the ECB and would also reduce the

EUR-USD misalignment with the long-term differentials between the eurozone and the US,

which have narrowed this year, in both nominal and real terms (Chart 4). If the Fed remains

steady on rates over the course of 2021, this would likely mean some consolidation, leading

to EUR-USD rising slightly to 1.18 at the most by the end of the year.

CHART 3: WORSENING IN GERMAN BUSINESS CLIMATE HAS PREVAILED OVER US SENTIMENT, DRIVING EUR-USD LOWER

CHART 4: EUR-USD STILL OUT OF SYNC WITH NOMINAL AND REAL YIELD SPREADS BETWEEN THE EUROZONE AND THE US


1.04

1.06

1.08

1.10

1.12

1.14

1.16

85

90

95

100

105

110

Jan-19 Feb-19 Apr-19 Jun-19 Aug-19 Oct-19

German IFO (01-Jan-19 = 100)

US ISM PMI (01-Jan-19 = 100)

EUR-USD (rìs)1.08

1.10

1.12

1.14

1.16

1.18

1.20

-4.00

-3.50

-3.00

-2.50

-2.00

-1.50

-1.00

Jan-19 Feb-19 Apr-19 May-19 Jun-19 Aug-19 Sep-19 Nov-19

EU vs. US 2Y bond nominal spread

EU vs. US 2Y bond real spread

EUR-USD (rs)




…with one major risk: a more intense economic slowdown outside the US, which would boost the USDs role as a safe-haven

The major risk to our scenario is if the worldwide economic slowdown proves more intense in

the coming quarters, and notably outside the US, triggering in turn a meltdown in risk appetite.

This would magnify the role of safe-haven currencies, including the USD, and drive a lot of

portfolio flows back into the US from both developed and emerging countries. However, the

ample available liquidity will likely limit the extent of fund repatriation and so it would not spur

a massive sell-off and would not push EUR-USD much below 1.10.

JPY: still firmer, even if BoJ action steepens the Japanese curve considerably

We remain bullish on the JPY, as we still see significant threats to global risk appetite next

year. However, we see at least two factors that might slow the pace of the JPY rise. First, a

deal being reached on the current “Phase one” of the trade row between the US and China

would make safe-haven currencies like the JPY less attractive, but only temporarily, as such a

deal would not represent a definitive solution to the trade dispute. Second, the BoJ is set to

become more accommodative again, trying to steepen the Japanese yield curve by increasing

bond purchases at the medium and shorter maturities. The new easing is potentially JPY

negative (Chart 5), but it would not come as a surprise at this stage, as BoJ Governor Haruiko

Kuroda has already made his policy intentions clear. With global risk factors not being fully

alleviated and in the weaker USD scenario that we imagine, we think that USD-JPY still has

more room to fall than to rise. The pair may briefly exceed 110 in 1Q20, depending on the

timing of the BoJ’s increased bond buying, but we still target 105 in 4Q20 and 103 in 4Q21:

two further steps forward for USD-JPY on the convergence roadmap to its “fair-value”, which

has now slipped below 100 in our estimation.

GBP: room for rebound slowed by both risk of the Brexit “cliff edge” and BoE rate cuts

The sterling outlook continues to be mostly a Brexit story. At the time of this publication, the

Brexit deadline has been delayed to the end of January and a UK general election has been

called for 12 December. The probability of an agreement on the future trade relationship

between UK and EU before the end of the so-called “transition period” in December 2020 is

very low, but the risk of a no-deal/hard Brexit at the end of 2020 (the so called “cliff-edge”)

is still very real. This is because the decision to extend the transition period has to be taken

by 1 July 2020, meaning that Brexit uncertainty will be back again in seven months’ time.

A free trade agreement is not expected to be concluded by then and the main risk is that the

Euroskeptics in the Tory party will not accept an extension to the standstill transition period.

This scenario may limit the effective upside potential for sterling throughout most of 2020,

considering that the BoE will likely also cut the bank rate back to zero, in our view. The GBP-USD

and EUR-GBP levels prior to the 2016 referendum, above 1.40 and just below 0.85,

respectively, remain reference targets over our 2Y horizon (Chart 6), but sterling is not likely

to approach them until late 2021, if at all.

CHART 5: A STEEPER JAPANESE CURVE NOT ENOUGH TO PREVENT A WEAKER USD-JPY EXCHANGE RATE

CHART 6: STERLING HEADING BACK TO PRE- BREXIT REFERENDUM LEVELS


105

108

110

113

115

0.00

0.03

0.05

0.08

0.10

0.13

0.15

0.18

0.20

Jan-19 Feb-19 Apr-19 May-19 Jul-19 Sep-19 Oct-19

10Y vs. 2Y JGB spread USD-JPY (rs)

0.65

0.70

0.75

0.80

0.85

0.90

0.95

1.15

1.25

1.35

1.45

1.55

1.65

2015 2016 2017 2018 2019

GBP-USD EUR-GBP (rs)

Brexit referendum 23 June 2016




CHF: moderately loosening its grip against the euro

A deal Brexit would make the Swiss franc less attractive as a safe-haven currency in Europe.

We expect EUR-CHF to rebound back to 1.15 by 4Q21, which would represent an 8.5%

overvaluation with respect to our calculation of its fair value, now at 1.06. Yet, the SNB has

proved relaxed on the FX front so far this year, as indicated by the size of sight deposits, and

a weaker franc would actually be welcomed at this stage. Moreover, with policy rates still

below the ECB deposit rate (-0.75% vs.-0.50%), the SNB has no great incentive to alter its

stance to offer the franc support, unless external factors impose it, such as more ECB easing.

Although this is not in our scenario.

Commodity currencies: room for rebound delayed to 2021

The AUD, NZD and CAD will probably remain sluggish in 2020 due to a continuation of the

bleak world economic picture, including China slipping below 6.0% growth and lower oil

prices. Progress in trade negotiations between the US and China will probably offer just

temporary relief to these units. Aside from this, by their own standards, both the RBA and the

RBNZ have cut rates heavily this year, down to 0.75% and 1.00%, respectively. There is room

for more easing, but it is small. The BoC has not started an easing cycle yet, but it will likely

kick one off soon, leaving the CAD on a soft tone in 2020. A rebound for these three

commodity currencies may resume in 2021 if the global outlook improves and their central

banks become less expansionary.

Nordics: a slower and bumpier recovery from lows

The two Nordics remain greatly undervalued, especially the NOK after its drop to record lows

against the EUR. Based on our models, EUR-SEK and EUR-NOK should be around 9.10 and

8.90 compared to their current 10.70 and 10.10, respectively, but absorbing this misalignment

is unlikely to be easy. The Riksbank will likely hike this December and stay on hold at zero

thereafter, while the Norges Bank has already ended its tightening cycle. Neither the SEK nor

the NOK can therefore rely on tighter monetary policies at home in 2020 and 2021. They still

have margin to recover in the coming quarters, but less than they had in previous years.

CNY: trade uncertainty to favor more walks up and down the 7.00 threshold vs. the USD

USD-CNY has corrected sharply downwards from past peaks above 7.18 hit in September

thanks to progress in trade talks between Beijing and Washington. Early attempts to drag the

pair below 7.00 have already materialized and there is a chance of further declines, even

down to 6.90, in 2020. Still, the lower Chinese economic growth we expect would make the

PBoC more prudent about allowing more intense CNY appreciation. Trade tensions with US

may continue even if the “Phase one” has been finalized. If so, we think that there is a distinct

probability that USD-CNY might trade back above 7.00 throughout most of 2021.

ZAR: still firmer ahead, despite uncertainty on reforms and public finances at home

Worsening public finances in South Africa and risks of a new rating downgrade for the country

remain two clear burdens for the ZAR that may slow the pace of its recovery going forward.

The rescue plan announced for the state power utility has sharply weighed on the country’s

debt ratio, projected in the new budget plan to above 70% of GDP from the previous 56%.

Given the uncertainty that continues to surround the reform plans proposed by President Cyril

Ramaphosa, our previous target of 14.40 for USD-ZAR is probably more likely to be reached

in 2021 rather than 2020, for which 14.60 looks to be the best the ZAR can achieve.

CEE Currencies Our view on CEE currencies is reported in the CEE macro section.




Appendix – FX BEER model updated

Elia Lattuga Deputy Head of Strategy Research Cross Asset Strategist (UniCredit Bank London) +44 207 826-1642 [email protected] Roberto Mialich FX Strategist (UniCredit Bank, Milan) +392 88 62-0658 [email protected]

We have further refreshed our FX fair-value model, BEER by UniCredit, after the update

made in June18

. The text and the table below sum up major changes to our estimates. Using

a confidence threshold of +/-5% with respect to fair values:

■ EUR-USD remains fairly valued, with its equilibrium level unchanged at 1.15;

■ GBP remains sharply undervalued due to Brexit uncertainty: the fair values for GBP-USD and EUR-GBP are now around 1.46 and 0.79, broadly unchanged from June

■ USD-JPY has become more overvalued, as its fair level has dipped to 95.7 from 101.2; likewise the fair value for EUR-CHF is now at 1.06 vs. 1.12 in June.

■ The AUD is still undervalued against the USD, while both the NZD and the CAD are fairly valued. SEK and NOK show the largest undervaluation in the G10 group.

■ In the CEE3 space, our model detects only a modest undervaluation of the HUF against the EUR.

FAIR VALUATION OF G10 AND CE3 FX ACCORDING TO BEER BY UNICREDIT

Current BEER by UniCredit Misalignment undervalued* fairly valued* overvalued*

EUR-USD 1.11 1.15 -3.8%

EUR-USD

EUR-CHF 1.10 1.06 4.3%

EUR-CHF

EUR-GBP 0.86 0.79 9.0%

EUR-GBP

EUR-JPY 121 110 9.5%

EUR-JPY

EUR-NOK 10.16 9.33 8.9%

EUR-NOK

EUR-SEK 10.66 9.09 17.3%

EUR-SEK

EUR-AUD 1.61 1.46 9.8%

EUR-AUD

EUR-NZD 1.74 1.72 0.8%

EUR-NZD

EUR-CAD 1.46 1.46 0.3%

EUR-CAD

EUR-PLN 4.27 4.26 0.1%

EUR-PLN

EUR-HUF 332 344 -3.6%

EUR-HUF

EUR-CZK 25.5 28.2 -9.5% EUR-CZK

USD-CHF 0.99 0.92 8.4%

USD-CHF

GBP-USD 1.29 1.461 -11.8% GBP-USD

USD-JPY 109 95.7 13.9%

USD-JPY

USD-NOK 9.13 8.09 12.9%

USD-NOK

USD-SEK 9.61 7.88 21.9%

USD-SEK

AUD-USD 0.69 0.79 -12.4% AUD-USD

NZD-USD 0.64 0.67 -4.6%

NZD-USD

USD-CAD 1.32 1.26 4.2%

USD-CAD

USD-PLN 3.85 3.70 4.1%

USD-PLN

USD-HUF 300 299 0.3%

USD-HUF

USD-CZK 23.0 24.4 -5.9% USD-CZK

USTW$ index 91.6 85.8 6.8%

USTW$ index

*using a threshold of +/- 5% Source: Bloomberg, UniCredit Research

18

See UniCredit Research FX Perspectives no. 62 - Updating our BEER model: fundamental support for the US dollar is waning. About our methodology, see the original

version of our BEER model in UniCredit Global Themes - Introducing BEER by UniCredit, 3 September 2013.



https://www.research.unicredit.eu/DocsKey/fxfistrategy_docs_2019_172571.ashx?M=D&R=70331984

https://www.research.unicredit.eu/DocsKey/fxfistrategy_docs_2013_135939.ashx?EXT=pdf&KEY=KZGTuQCn4lsvclJnUgseVFYZc3L2g_PGD0dh2UFWWMIbGa5daoHXhg==&T=1




Equity Strategy

Downside risks to prevail, particularly in 1H20

Christian Stocker, CEFA, Lead Equity Sector Strategist (UniCredit Bank, Munich) +49 89 378 18603 [email protected]

■ We anticipate strong corrections of up to 20% in global equities in 1H20, with some relief

by year-end 2020. Our 2020 year-end target for the Euro STOXX 50 is 3850, for the DAX

14000 and for the MSCI Italy 67.

■ 2020 will be dominated by low earnings growth in Europe and slowing earnings growth in

the US. We consider consensus estimates to be far too high.

In 2020, equity markets will be caught between very low economic growth in Europe and

deteriorating growth in the US, on the one hand, and ongoing supportive monetary policy of

major central banks on the other hand. At the same time, equity-market valuations have

gradually reached their limit, thus putting a cap on further upside potential. Therefore, our

expectations for the development of equity markets in 2020 are very modest, with estimated

year-end targets for the Euro STOXX 50 of 3850 index points, 1400019

for the DAX and 67 for

the MSCI Italy. The main risk for global equity markets, besides trade issues, is the economic

slowdown we expect to occur in the US, which might even lead to recessionary levels in

2H20. Therefore, we see the high probability of a substantial market correction of around 20%

in the course of 1H20 whose trigger would be the significant economic slowdown in the US

and the realization that the structural theme of this current economic end-cycle will prevent a

noteworthy global cyclical recovery in 2020. The development of equity markets in the second

half of 2020 might be dominated by stabilization efforts, which should be supported by a

more-constructive view on the economic development in 2021 (albeit only moderate initially) and

ongoing accommodative central-bank policy. On balance, this might provide some relief to equity

markets, and may push the index levels up again, to the year-end targets that we forecast.

CHART 1: EUROZONE GDP GROWTH AND EARNINGS ESTIMATES

CHART 2 : EARNINGS ESTIMATES AND CALCULATED EURO STOXX 50 PRICE TARGET 2020


Low-single-digit Euro STOXX 50 earnings growth expected

Chart 1 shows eurozone GDP growth in percent yoy with UniCredit and Bloomberg estimates

for 2020/21 as well as growth of Euro STOXX 50 earnings estimates for 2020 that we have

modelled based on our GDP estimates. In this regard, it is important to highlight that our GDP

forecast is below consensus estimates and, therefore, also our earnings-growth estimates

19

Note: The calculated 2020 year-end target of the DAX is about 7% above current levels, while the Euro STOXX 50 and MSCI Italy levels are just 4% above

current levels. This difference does not imply a significantly better scenario for the DAX. The higher expected percentage increase results from the fact that the DAX is a performance index and, therefore, dividends are included in the DAX performance (we estimate a dividend yield of 3%), while Euro STOXX 50 and MSCI are pure price indices with dividends paid subtracted from equity prices.

-60

-40

-20

0

20

40

-6

-4

-2

0

2

4

2003 2005 2007 2009 2011 2013 2015 2017 2019 2021

Eurozone GDP, yoy in %Bloomberg GDP consensus estimates, yoy in %UniCredit GDP estimates, yoy in %Euro STOXX 50 12M fwd. earnings est., in % yoy, 4Q19-4Q21 UCG est.(rs)

1500

2000

2500

3000

3500

4000

4500

150

200

250

300

350

400

450

2003 2005 2007 2009 2011 2013 2015 2017 2019

12M fwd. earnings est., 4Q19-4Q20 UCG estimateEuro STOXX 50 (rs)Euro STOXX 50, UCG estimate (rs)





differ strongly from consensus expectations (see Table 1)20

. Against this background, we

think that 2020/21 eurozone and US consensus earnings estimates are far too high and,

therefore, might experience strong downward revisions, particularly in 1H20. This, in

combination with high valuation levels going into 2020, and increasing awareness of

significantly slowing US GDP growth during 2020, is reflected in our expectation of a strong

equity-market correction of up to 20% in the first half of 2020. Chart 2 above depicts the flat

course of our Euro STOXX 50 earnings estimates. While some further central bank action is

broadly discounted, we expect more Fed rate cuts than consensus. This should support P/E

valuations over the course of 2020. Our slightly positive year-end target for the Euro STOXX 50

of 3850 points (4.5% above the current level) is based on our assumption that the P/E ratio will

slightly increase from 14 currently to 14.6 due to ongoing accommodative central-bank policy.

TABLE 1: GROWTH OF EARNINGS ESTIMATES (CONSENSUS AND UNICREDIT)

CHART 3: VIX AND NET VIX FUTURE POSITIONS

yoy % 2019E 2020E UCG 2020E 2021E

S&P 500 1.3 9.3 n.a. 10.6

Euro STOXX 50 1.5 10.5 3.5 8.0

DAX -4.2 13.5 6.0 11.2

MSCI Italy 4.4 6.2 n.a. 6.9

Source: Refinitiv Datastream, Bloomberg, UniCredit Research

Bigger swings in 2020 History tells us that in an environment of sluggish or slowing economic growth rates (which we

expect particularly for the US) and, as a result, decreasing growth of company earnings,

implied volatilities in equity markets increase. Against this background, the current high

degree of investor complacency in the US could be a harbinger of bigger equity market

swings in the next few months. Investors have become ever so comfortable with the current

period of low volatility and are betting it could fall even further in the coming months. This is

reflected in the fact that net-short positions in the CBOE Volatility Index (VIX) futures rose to their

highest level ever, according to the latest Commodity Futures Trading Commission data. Chart 3

shows the correlation between the volatility-short-positioning level (with a lead of 3M) and the

performance of the S&P 500. While an extraordinarily high volatility-short-positioning level is

certainly no timing indicator, it nevertheless indicates the high degree of investor complacency

currently. This makes equity markets particularly vulnerable to sentiment shifts and event risk. In

the past, such high levels of complacency were often followed by a strong decline in the S&P 500

(such as in February 2018 or 4Q18), which will also be reflected in a decline of other developed

equity markets given the role of Wall Street as the world’s leading stock market.

Elevated valuations cap positive potential

Since the start of 2019, the P/E valuation of the Euro STOXX 50 has increased by almost

25% and that of the S&P 500 by 30%. Chart 4 shows the correlation between the eurozone

manufacturing PMI and the P/E ratio of the Euro STOXX 50. Since early 2019, the two time

series have been developing in opposite directions so far, which is uncommon in historical

terms. This year’s increase in the P/E valuation is mainly based on very accommodative US

and ECB central-bank policy. We do not expect central banks to change their policies in the

foreseeable future, which implies that this might continue to support valuations and, therefore,

20

We calculated our earnings-growth estimates based on a regression model comparing past GDP growth and growth of earnings estimates from 2003 until 3Q19.

The model has a solid R2 of 0.87 over this time period.

-25

-15

-5

5

15

25

-250000

-150000

-50000

50000

150000

250000

2015 2016 2017 2018 2019 2020

CFTC Cboe VIX futures non-commercial net total, shifted by 3M

S&P 500, 3M change in % (rs)




we expect a slightly higher P/E ratio for the Euro STOXX 50 of 14.6 at the end of 2020. A P/E

valuation above the level of 14.6 (which reflects past highs) is highly unlikely against the

background of a looming slowdown in the US and ongoing subdued economic growth in

Europe. This is also depicted in Chart 5. Apart from individual events, such as the ECB’s

announcement of massive QE early in January 2015 or the US corporate tax reform

announced at the end of 2017, valuations of the Euro STOXX 50 and the S&P 500 are around

their multi-year highs heading into 2020. On balance, we think that the underlying support by

monetary policy will continue, but as long as valuations are not supported by fundamental

improvements in economic data, such valuation levels are basically fragile. Therefore, an

upcoming setback of up to 20% is likely and not unusual in late stages of the economy. Such

a correction would bring the Euro STOXX 50 down to a P/E ratio of 12, which means an index

level of 3100 points (corresponding index levels for the DAX 11000, S&P 500 2500). With

indications of a more-constructive view on the economic development in 2021, most probably

in the course of 2H20, valuations have the potential to recover again.

CHART 4: EUROZONE MANUFACTURING PMI AND P/E RATIO CHART 5: P/E RATIO OF EURO STOXX 50 AND S&P 500

Source: Refinitiv Datastream, UniCredit Research

What if we are wrong and consensus is right?

Our economic forecasts and, therefore, our earnings estimates are below-consensus views (see

Table 1 above). Should consensus earnings estimates be proven right and economic growth

surprise to the upside globally, the resulting equity-market potential would be accordingly higher.

This would offer additional positive potential of 5-10% above our forecast for the Euro STOXX 50.

For the DAX, with its strong cyclical exposure, the potential would be even higher.

We recommend a defensive allocation

We think the global growth environment remains too weak to support a lasting outperformance

of industrial sectors21

and that the cyclical rally since 3Q19 will be running out of steam going

into 2020. Although we expect some tentative signs of an economic bottoming-out in Europe,

the main European export markets, such as the US and Asia, might be caught in an

environment of slowing growth. Chart 6 shows that earnings estimates in defensive sectors22

continue their strong growth, while earnings estimates in industrial sectors continue to decline.

We do not expect that this behavior of more-favorable earnings development in defensive

sectors compared to industrial sectors will materially change in 2020. Therefore, we recommend

a defensive allocation and prefer sectors such as Food & Beverage, Health Care, Personal &

Household Goods and Utilities. As Chart 7 suggests, industrial sectors might achieve lasting

outperformance only upon confirmation of again notable growth of global trade volumes. 1

21

Industrial sectors (“industrials”): Automobiles & Parts, Basic Resources, Chemicals, Construction & Materials, Industrial Goods & Services 22

Defensive sectors (“defensives”): Food & Beverage, Health Care, Personal & Household Goods, Telecommunications, Utilities

6

8

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30

35

40

45

50

55

60

65

70

2003 2005 2007 2009 2011 2013 2015 2017 2019

Eurozone manufacturing PMI

Euro STOXX 50: P/E based on 12M fwd. earnings estimates (rs)

6

8

10

12

14

16

18

20

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Euro STOXX 50, P/E ratio based on 12M fwd. earnings estimatesS&P 500, P/E ratio based on 12M fwd. earnings estimates




CHART 6: EARNINGS ESTIMATES OF INDUSTRIALS AND DEFENSIVES

CHART 7: GLOBAL FOREIGN TRADE VOLUME AND RELATIVE PERFORMANCE OF INDUSTRIALS/DEFENSIVES

Source: Refinitiv Datastream, UniCredit Research

EQUITY SECTOR ALLOCATION WESTERN EUROPE

STOXX Europe 600 Sector

Benchmark weight

(%)

Portfolio weight over/underweight –

(%-points)

Portfolio position

(%)

Strength of over/underweight

in % of sector weight

Automobiles & Parts 2.5 -1 1.5 -39

Banks 10.2 0 10.2 0

Basic Resources 2.6 0 2.6 0

Chemicals 4.5 -1 3.5 -22

Construction & Materials 3.3 0 3.3 0

Financial Services 2.3 0 2.3 0

Food & Beverage 6.2 1.5 7.7 24

Health Care 14.5 1 15.5 7

Industrial Goods & Services 11.8 -1 10.8 -8

Insurance 6.4 0.5 6.9 0

Media 2.0 -1 1.0 -49

Oil & Gas 5.2 0 5.2 29

Personal & Household Goods 8.6 1 9.6 12

Real Estate 2.3 -0.5 1.8 -22

Retail 3.0 0 3.0 0

Technology 5.3 0 5.3 -19

Telecommunications 3.3 0 3.3 0

Travel & Leisure 1.5 -0.5 1.0 -32

Utilities 4.4 1 5.4 23

Source: STOXX Ltd., UniCredit Research

90

100

110

120

130

140

2013 2014 2015 2016 2017 2018 2019

Defensives: 12M fwd. earnings estimates (2013=100)

Industrials: 12M fwd. earnings estimates (2013=100)

0,9

1,1

1,3

1,5

1,7

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40

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2007 2009 2011 2013 2015 2017 2019

Ifo World Economic Survey, foreign trade volume next 6MMSCI World: relative performance industrials/defensives (rs)




Credit Strategy

Investment grade: cashing in carry in a prolonged late cycle

Dr. Stefan Kolek EEMEA Corporate Credit Strategist (UniCredit Bank, Munich) +49 89 378-12495 [email protected]

■ The late-stage credit cycle warrants a defensive positioning in European investment grade

(IG): we prefer non-cyclical credit sectors and have only tactical overweights in selected

cyclical sectors with still-good credit fundamentals and yield pick-up in 2020.

■ The benign technical backdrop on the back of the resumption of corporate bond purchases

by the ECB and the expected decline in net issuance should provide support. We expect

the iBoxx Non-Financials and Financials indices’ spreads to amount to 60bp by the end of

the next year. This is close to current levels and should contribute to further widening in the

gap between valuations and credit fundamentals.

Late-stage credit cycle likely to be prolonged by dovish central banks

We remain in the late stage of the credit cycle, with the recently implemented QE II by the

ECB and the expected rate cuts by the Fed likely to further prolong this phase. While our

below-consensus eurozone economic-growth forecast argues in favor of spread widening, i.e.

a realignment of credit spreads with the economic growth dynamics, the relaunch of asset

purchases by the ECB and the related hunt for yield suggest a widening of the gap between

fundamentals and valuations in European credit in the coming months (Chart 1).

Cyclicals’ credit fundamentals already feeling the downturn

The late-stage cycle is feeding through into negative credit-rating dynamics, with cyclical

sectors, e.g. Retail, Media and Capital Goods & Services hit hardest YTD (Chart 2). Given the

expected mild recession in the US, credit metrics of US issuers could experience more

pressure than those of European peers. This is important given that US issuers make up

around 30% of this year’s issuance, driven by appealing cross-currency swaps, which has

reduced funding costs in the European markets. However, iBoxx US IG issuers’ credit-rating

profile is still comparable to that of eurozone peers, and with a large part of IG issuers rated

between A and BBB, we see only limited risk of “fallen angels” over the next twelve months.

European banks are in a better fundamental position than cyclical non-financials

In our view, the picture for the European Banks sector looks better than for Non-Financials

cyclicals. As depicted in Chart 2, upgrades in 2019 in the financial institutions sector by far

exceed downgrades (S&P data), with the positive net change being strongest among

individual credit sectors. Although the weaker growth backdrop will weigh on banks’ asset

quality going forward, the current good capitalization, a decline in non-performing loans and

liquidity provision by the ECB are likely to alleviate the impact of slower growth on Banks

credit relative to their Non-Financial peers. The lower profitability on the back of the low-

interest environment and flat yield curve, while being negative for equity, is neutral for credit.

CHART 1: ITRAXX NON-FINANCIALS VS. ECONOMIC GROWTH EXPECTATIONS

CHART 2: YTD RATING DYNAMICS IN EUROPEAN FINANCIALS AND NON-FINANCIALS

Source: Bloomberg, Matkit.com, S&P, UniCredit Research

-0.85%

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Consensus projection UniCredit forecast

-10 -5 0 5 10 15

Retail

Media/entert

Cap. goods

Cons. Prods

Forest Prods

Oil & Gas

Utilities

Technology

Autos

Transport

Healthcare

Chemicals

Real Estate

Telcos

Metal & Mining

Insurance

Financial Insts.

No. of rating actions

Upgrades 2019 Downgrades 2019 Net





Technical factors remain key to the widening of the gap between valuations and fundamentals

The technical backdrop is the key argument why valuations in European credit will not align

with fundamentals in the coming months. First, extraordinary policies by the ECB will keep

interest rates at negative yields in a large part of the fixed income universe, leaving investors

looking for yield. Second, although the announced asset purchases by the ECB of EUR 20bn

per month (we estimate these to include up to EUR 4bn of corporate bond purchases per

month) are significantly lower than in 2016-2018, the key difference – the commitment by the

ECB to buy paper for an unlimited time – creates a kind of “anticipatory factor support.”

Moreover, the net asset purchases need to be added to the re-investment of redemptions,

which we estimate to amount to up to EUR 2.5bn per month (Chart 3). Third, this, coupled

with the expected decline in net issuance, should provide Investment Grade Non-Financials

with technical support. We expect net issuance to decline on the back of lower capex and a

lack of (debt-funded) M&A activities, as well as a decline in issuance from US corporates, as

the expected rate cuts by the Fed will reduce the funding advantage in euro relative to USD.

Expected net-supply backdrop further argues for defensive sectors

Besides the mentioned fundamental arguments in favor of defensive sectors – notably the

deteriorating growth picture – the distribution of the expected net supply across the individual

sectors underpins our preference of defensive sectors: using the expected issuance volume

of corporates in our coverage, Chart 4 shows that primarily the defensive sectors, such as

Telecoms, Healthcare, Personal & Household Goods, Food & Beverage as well as Utilities

are seen ending next year with negative net issuance. In the cyclical sectors – Chemicals,

Technology, Automotives & Parts, Basic Resources and Industrial Goods & Services – we

expect positive net supply, which should weigh on the performance in these sectors. We

expect the net supply of senior bank debt to be lower than it was this year and the net supply

of subordinated bank debt to be comparable to this year’s levels.

Investment ramifications: we remain defensive in sectors and prefer Banks to Non-Financials Subordinated debt

In terms of strategic ramifications, the above-mentioned forces – the late-stage credit cycle and its

impact on fundamentals and technical factors – should balance out and we expect spreads in both

Banks and Non-Financials Investment Grade Seniors to end next year close to this year’s levels. In

Non-Financials, we stick with our preference of defensive sectors over cyclicals and have only

tactical overweights in selected cyclical sectors (Basic Resources and Construction & Materials)

which still have good credit fundamentals and offer a yield pick-up. The dovish stance of major

central banks should reduce the risk of volatility going forward, which, coupled with tight spreads in

Senior bonds, should keep the appetite for carry high in the Subordinated universe. In the latter,

we see better value in Banks Subordinated debt, where we expect, on balance, stable credit-risk

premiums, while in Non-Financials Subs, the deteriorating credit metrics and the absence of the

ECB bid should result in moderate (20bp) spread widening. A further supportive factor is the better

credit quality in Banks Subordinated debt with most issuers concentrated in the A- and BBB+

rating brackets, while the NFI Subs rating distribution is skewed towards the BBB- rating bracket.

CHART 3: CSPP MONTHLY PURCHASES, EXPECTED REDEMPTIONS AND IBOXX NON-FINANCIALS NEW-BOND SUPPLY

CHART 4: NET BOND SUPPLY FROM IBOXX NON-FINANCIALS ACROSS SECTORS (UNICREDIT COVERAGE)

Source: Markit.com, ECB, UniCredit Research

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R b

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Expected reinvestment Expected net purchasses

Reinvestments Primary market purchases

Secondary market Net issuance (12M MA)

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E

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n Expected iBoxx NFI net supply




High yield: marked spread widening expected amid economic slowdown

Holger Kapitza Credit & High Yield Strategist (UniCredit Bank, Munich) +49 89 378 28745 [email protected]

■ European HY credit markets will be caught between a continued slowdown of economic

and earnings growth and support factors, such as the hunt for yield, which will benefit HY

credit from a technical perspective. However, European companies should remain less

vulnerable to credit concerns than their US peers.

■ As the macroeconomic environment will remain the dominant driver for HY credit next year,

which will be in line with continuously weaker credit metrics and rising defaults, we expect the

spreads among HY rating categories to continue to diverge, mainly due to the hunt for safety.

Overall, we see a marked widening of credit spreads in the European HY market next year.

Continued slowdown of the economy will remain a major driver for HY markets in 2020

Given the low-yield environment, HY credit markets will remain attractive for credit investors

next year. This comes at a time, when economic growth is slowing due to uncertainty on

global trade, earnings growth of US and European companies is weak and credit markets

have entered the end of the credit cycle. Technical support factors, such as the resumption of

the CSPP, which will spur the hunt for yield, will also benefit HY markets from a technical

perspective, although this will be likely balanced by a deterioration in credit fundamentals, in

our view. European HY credit has rallied this year and, amid the flight to rating quality, the

spread dispersion in HY will likely continue in 2020. The spread dispersion is a sign that

investors are concerned about the weakening of economic fundamentals, rising downgrades

and the worsening of credit metrics. In terms of spread dispersion, there is less difference

between Europe and the US, but we see more downside risks in the US. To conclude, we see

considerable credit spread widening pressure in European HY (our spread forecast is 450bp

at FYE 2020, compared to the current level of 350bp), while a likely rise in default rates is

likely to penalize HY bond markets. We recommend investors take a selective and cautious

approach to HY credit and look for bonds that offer decent carry in European HY markets.

CHART 1: OUR MACRO-CREDIT MODEL FOR EUROPEAN HY NFI

CHART 2: EUROPEAN HY MARKETS: SPREAD DIVERGENCE BY RATING

Source: Bloomberg, Markit iBoxx, UniCredit Research

In line with our macro-credit model, HY credit spreads are likely to widen materially

Given our expectation of a continued economic slowdown, we used our macro-credit model to

assess the spread widening pressure on European high-yield bonds. As shown in Chart 1, the

model depicts an inverse correlation of credit spreads with 12M forward consensus growth

expectations, while spreads have the tendency to react to changes earlier. This is why we

shifted growth expectations by two months. In the chart, we also show a projection of

consensus growth extended to 2021 (black dots) and our own growth forecast (dotted line).

Our projection assumes a continued weak economic growth environment in the eurozone of

0.8% (compared to expected average growth of 1.2% for the full-year 2019). This is in contrast

-0.7%

-0.2%

0.3%

0.8%

1.3%

1.8%

2.3%0

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Consensus projection (rs)

UniCredit forecast (rs, 12M fwd growth, annualized qoq)

Spread forecast

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to the projected consensus growth expectations, which show a moderate rebound in growth

expansion to about 1.2% in 2020. Based on our own projection, credit spreads of European HY

would materially widen to around 600bp in 2020 given the economic environment.

Due to technical factors, however, our FYE 2020 spread forecast for HY is 450bp

Notwithstanding some widening pressure for HY due to the sluggish economic backdrop, there

are some technical factors that argue against such a dramatic shift compared to current levels

(the iBoxx HY NFI is 350bp). First, HY credit remains highly sought after given the low-yield

environment, considering the significant amount of negative-yielding bonds in IG markets.

Second, the resumption of the CSPP will strengthen the hunt for yield, which will also benefit HY

markets. Third, after this year’s supply rally (YTD new HY supply is up significantly, by 9.2%

yoy), we expect new issuance likely to ease somewhat in 2020, which will provide support to

secondary markets. The iBoxx HY is trading at 350bp, compared to this year’s peak of 450bp,

while the iTraxx Crossover, which has a different structure, is trading at 235bp (compared to its

YTD high of 370bp). Assuming that spreads move range bound until the end of 2019, settling at

350bp in HY, we set our end-2020 target for HY markets at 450bp.

HY credit and total-return projection

For these reasons, we expect the yield change in HY to amount about 100bp. Considering an

average duration of 4.2Y and current yield-to-worst of 3.5% for HY, this will result in a 12M

total return of 3.1% at end-2020. This is mainly due to the high carry in HY, which provides a

cushion against potential spread widening. However, the attractive return projections for HY

(in particular when compared to IG) have to be weighed against the greater default risk

present in the market (see below).

Due to less-than-bright economic backdrop, we recommend European HY investors remain selective, preferring defensive sectors

Against the background of renewed demand for risky assets, European HY markets have

performed strongly this year notwithstanding a weakening of fundamentals as European

growth decelerates. Amid a flight to rating quality, the rally in HY markets has especially

benefited BB rated bonds, which significantly tightened this year, thereby outperforming B

rated bonds which narrowed less in relative terms. On the other hand, the lowest rating quality

of CCC rated bonds were in less demand as they widened YTD. Overall, credit spreads in HY

have diverged this year (Chart 2). Moreover, the hunt for safety in HY is also reflected in the

B/BB spread ratio differential of European corporate bonds, which has risen over the course

of the year (Chart 2) and is close to recent peaks. Notwithstanding the richening of BB rated

bonds, we think that BBs will be further supported by the introduction of the new CSPP. From

a tactical perspective, we even see spread-tightening potential for B rated bonds in the near

term as they have lagged behind in the recent spread rally. The near-term effect, however,

should diminish as the credit cycle moves forward and economic growth cools further. Given

the less-than-bright economic backdrop, however, we are sticking to our view that investors in

B rated bonds should remain selective and should show a preference for corporate debt from

less-cyclical sectors.

European and US HY show similar patterns but we see more downside risk factors in the US

A picture similar to that in Europe is becoming evident in the US HY market. The lowest rating

category in the US HY universe, namely bonds from CCC rated companies, have significantly

underperformed this year. US investors have also shifted their attention to higher-rated HY

bonds this year, as B and BB rated bonds have narrowed markedly, while investors have

slightly overweight exposure to B rated bonds in the US, compared to Europe. As a result,

differences in credit spreads among rating categories have also increased in the US. This is

also reflected in the drop in yields of higher-rated HY bonds in the European and US HY

market (Chart 3). However, high-yield credit overall remains a key part of the investment

strategy in Europe and the US as yield remains scarce in global bond markets. Nevertheless,

credit fundamentals are deteriorating, particularly in the US. This has mainly been driven by

an increase in the leverage ratios of US corporates, which could also spill over to European

HY markets as sentiment turns sour. Investors should be aware of this risk as we expect a

(mild) recession to materialize in the US in 2020, and such an economic slowdown could trigger

a substantial volume of downgrades of US corporates to non-investment grade.




CHART 3: EUROPEAN VS. US YIELD DEVELOPMENT (YTW)

CHART 4: EUROPEAN VS. US DEFAULTS: STARTING FROM LOW LEVELS, EUROPEAN DEFAULTS WILL LIKELY RISE BUT SHOULD OUTPERFORM THOSE OF THE US

Source: Bloomberg, ICE BofAML, Markit iBoxx, Moody’s, UniCredit Research

Defaults are on the rise, in particular in the US

Default rates among European HY bond issuers also suggest a cautious and selective

approach. So far, HY defaults have remained low by historical standards, comparable with

levels last seen prior to the financial crisis. Moody’s expects European defaults to remain low in

the near-term compared with rising defaults in the US (Chart 4). The agency also expects

European defaults to catch up to the US rate by end of 3Q20 (to 3.7%). In contrast to Moody’s

approach, however, we see a mildly superior performance in European defaults compared to

the US, which, in our view, is warranted by better economic circumstances in Europe next year

and the better shape in which European companies find themselves (Chart 4). A rising default

rate in Europe, is, however, largely not yet priced into HY markets.

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European default rate Europe baseline forecast




CEEMEA Strategy

Solid performance amid hunt for yield

Dr. Stefan Kolek EEMEA Corporate Credit Strategist (UniCredit Bank, Munich) +49 89 378-12495 [email protected]

■ EM hard-currency credit is facing headwinds from the global economic backdrop and the

resulting sell off in equities that is expected to occur. However, the hunt for yield, this asset

class’s still-solid credit quality and its close correlation with USTs should provide support.

■ The primary market should remain open for EM issuers, facilitating the refinancing of heavy

redemptions. In emerging Europe, we expect up to USD 50bn in new corporate issues.

We expect to see 5.4-5.8% in total return on EM corporate credit next year

We expect the yield on the JPM CEMBI index and its emerging European component to tighten

by 20-30bp (from currently 4.5% and 5%, respectively) by the end of the next year. This should

translate into total return of around 5.5% next year. This is less than half of the total return

generated YTD (11.9% and 15.1% respectively) and is slightly below the 6.4% average of the

past ten years. This asset class is facing headwinds from the global economic backdrop and the

resulting sell off in equities that is expected to occur. Nevertheless, these factors should be

counteracted by supportive factors: decent carry (which attracts “yield tourists” from crossover

investors amid dovish Fed and ECB policies), credit quality (which remains solid on balance), fair

valuations, high correlation with USTs and relatively low correlation with US HY credit. Our

preference remains oriented towards BBB and BB rated credit and credit from emerging Europe.

EM growth expected to accelerate, which would be EM credit supportive

EM corporate credit spreads have recently become decoupled from global GDP growth

(Chart 1). Easy financing conditions and yield hunting are behind a gap that is now larger than

it was during the ECB’s first round of quantitative easing (QE). While deteriorating global

growth has created headwinds for EM credit, we believe that the performance of the CEMBI

index will not be derailed. Our expectation of a slowdown of the global growth rate to 2.7%

from 3% should support credit-investor-friendly corporate policies and limit the risk that fallen

angels will emerge (the index includes only a minor share of BBB- rated issues on watch

negative). The large share of IG-rated names should attract crossover investors seeking yield.

Inflows into EM have recovered and odds are in favor of them continuing

Risk aversion will likely prevail globally during the expected growth slowdown. However, the

shallowness of the projected US recession and that the Fed is expected to cut rates to a greater

degree than expected should raise the chances that a meltdown in risk appetite and a sizable

repatriation of funds will be avoided. Given the hunt for yield, EM debt portfolios are likely to see

additional inflows. Inflows into EM debt have recovered since 2H18, and while they remain below

2017’s levels, they are still around levels seen in 2014 (during the Fed’s third round of QE). Most

inflows have been into Asian debt (Chart 2), which is largely IG-rated and tends to attract

crossover investors. Emerging European debt continues to be a capital-flow destination, although

inflows have resumed since September, mainly due to a recovery in sentiment towards Turkey.

CHART 1: GLOBAL GDP VS. JPM CEMBI SPREAD INDEX CHART 2: PORTFOLIO INFLOWS INTO EM DEBT

Source: Bloomberg, JPMorgan, IMF, International Institute of Finance, UniCredit Research

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No

v-1

5

Apr-

16

Sep

-16

Fe

b-1

7

Ju

l-1

7

De

c-1

7

Ma

y-1

8

Oct-

18

Ma

r-19

Aug

-19

US

D b

n

Africa & Middle East Emerging Europe

Latin America Emerging Asia

12M moving average





We expect USD 40-50bn in new issues from emerging European issuers

The expected decent inflows into EM credit should help to absorb new bond supply, which is

likely to remain strong also next year. USD 434bn of new issues have been placed by EM

corporates YTD, i.e. 23% more than in the same period last year. Next year, EM corporates face

USD 402bn (USD and EUR paper) of redemptions. Bond refinancing, bond calls, prefunding

2021 maturities (which we estimate at USD 350bn) and refinancing loans with bonds are drivers

expected to remain at work in the primary market also next year. At the same time, ample liquidity

coupled with appetite for EM credit risk should keep the primary market open. In emerging

Europe, corporates will redeem USD 33.6bn of bonds in 2020 and USD 30.0bn in 2021 (Chart 3),

which we expect to be refinanced. In addition, Russian corporates face USD 1bn in callable

bonds next year that could also be called and refinanced. All in all, in emerging Europe we expect

USD 40-50bn in new issues in 2020. Besides refinancing, we expect more inaugural paper from

Russian and CEE issuers switching bank loans into bonds (which will contribute to broader

diversification of the market). Moreover, the recent history of increased application of financial

sanctions by the US administration will likely lead EM issuers to diversify their funding sources.

We expect a higher share of euro-denominated issuance, particularly from Russian corporates.

Relative value We view EM corporate credit as fairly valued compared to US BB and BBB rated corporate

debt. As Chart 4 shows, the spread between EM and US BB HY debt is slightly above its two-

yield average and BBB rated EM corporate debt trades close to its two-year average spread

to BBB US corporates, which suggests fair pricing. This is important given the high relevance

of crossover investors, who are interested in particular in IG EM bonds. Given the expected

decline in UST yields, we recommend outright positioning in EM credit. However, we think the

performance will stem primarily from carry, with headwinds from the expected US recession

given the significant correlation between US and EM corporate debt.

Key risk factors include global growth and US-China relations

The key risk to our benign view on EM credit is a deeper-than-expected US recession. In this

context, however, we think within the index emerging European corporates should benefit from their

significant exposure to domestic and eurozone markets. A potential escalation in US-China

tensions could pose another risk, especially if it were to feature financial sanctions against

Chinese banks or corporates. As a result of Chinese corporates’ making up 25% of the JPM

CEMBI index, a deterioration in the fundamental backdrop of Chinese corporates could pose

a risk to EM credit. While we are aware of idiosyncratic risk factors stemming from individual

markets (e.g. Argentina’s debt restructuring), EM credit’s broad diversification limits spillover risk.

Bottom line The bottom line is that we see EM credit as being fairly valued and expect to see only some minor

spread tightening to the end of 2020 amid the hunt for yield, with return being driven by carry.

Headwinds stem from the expected sell-off in equities and a shallow recession in the US, though

emerging European credit should benefit on a relative-value basis. Our preference remains for BBB

and strong BB rated EM credit, which offer decent yield pickup coupled with solid credit metrics.

CHART 3: EM AND EMERGING EUROPEAN USD AND EUR REDEMPTIONS

CHART 4: RELATIVE VALUE – BBB AND BB RATED CORPORATES IN THE US AND EM

Source: Bloomberg, JPMorgan, Bank of America Merrill Lynch, UniCredit Research

0

50

100

150

200

250

300

350

400

450

0

10

20

30

40

50

60

70

80

2020 2021 2022 2023

US

D b

n

US

D b

n

CEE Turkey Russia EM (rs)

0

20

40

60

80

100

120

140

160

180

No

v-1

7

Ja

n-1

8

Ma

r-18

Ma

y-1

8

Jul-18

Sep-1

8

No

v-1

8

Ja

n-1

9

Ma

r-19

Ma

y-1

9

Ju

l-1

9

Sep

-19

bp

BBB EM vs. US corporate yield difference

BB EM vs. US corporate yield difference

average yield difference

November 2019 November 2019

Macro & Strategy Research


OutlookMacro & Markets Outlook


Table 1: Annual macroeconomics forecasts

GDP (%)

CPI inflation (%)*

Central Bank Rate (EoP)

Government budget balance (% GDP)

General government debt (% GDP)

Current account balance (% GDP)

2019 2020 2021 2019 2020 2021 2019 2020 2021 2019 2020 2021 2019 2020 2021 2019 2020 2021

World 3.0 2.7 3.2 - - - - - - - - - -

US 2.3 1.1 0.9 1.8 1.7 1.5 1.75 0.75 0.75 -4.7 -5.1 -4.8 106.9 109.0 110.9 -2.4 -2.1 -2.0

Eurozone 1.2 0.8 1.0 1.2 1.0 1.1 -0.50 -0.50 -0.50 -0.8 -1.0 -0.9 88.4 88.9 89.2 3.5 3.3 3.3

Germany 0.6** 0.7** 0.8** 1.4 1.4 1.5 - - - 1.0 -0.3 -0.3 59.7 58.7 57.7 7.7 7.3 7.5

France 1.3 1.0 1.1 1.1 1.1 1.2 - - - -3.1 -2.4 -2.2 99.0 99.7 100.0 -0.4 -0.5 -0.5

Italy 0.2 0.2 0.5 0.6 0.7 0.8 - - - -2.2 -2.3 -2.3 136.2 136.6 136.8 2.8 2.7 2.6

Spain 1.9 1.4 1.5 0.9 0.9 1.1 - - - -2.3 -2.2 -1.9 96.6 96.2 95.7 2.4 2.5 2.2

Austria 1.5 1.0 1.3 1.5 1.5 1.8 - - - 0.5 0.2 0.2 70.4 68.3 66.1 2.3 2.3 2.4

Greece 1.6 1.9 2.1 0.3 0.5 0.8 - - - 1.3 1.0 1.0 174.7 169.4 163.8 -0.9 -1.1 -0.8

Portugal 1.9 1.5 1.5 0.2 0.5 0.7 - - - -0.1 -0.1 0.2 119.4 117.2 114.1 -0.4 -0.5 -0.5

CEE

Poland 4.1 3.2 3.4 2.9 2.9 2.5 1.50 1.50 1.50 -1.2 -1.7 -2.0 46.8 45.9 45.5 -0.3 -1.0 -0.6

Czechia 2.4 1.9 2.0 2.8 2.5 2.1 2.00 1.75 1.50 0.0 -0.7 -1.2 30.8 30.1 30.1 1.0 1.4 1.5

Hungary 4.8 2.7 2.9 3.8 3.2 3.3 0.90 0.90 0.90 -1.8 -1.3 -2.0 67.7 66.2 65.7 -1.2 -0.8 -0.3

Russia 1.1 1.1 1.4 3.3 3.5 4.0 6.25 5.75 5.75 1.1 0.3 0.2 12.4 13.7 14.5 5.0 4.1 4.1

Turkey 0.3 2.2 3.1 11.7 9.6 8.9 12.0 10.0 10.0 -5.5 -5.1 -4.9 30.9 31.8 33.2 0.3 -1.5 -1.9

Other Europe

UK 1.3 0.8 0.9 1.8 1.3 1.5 0.75 0.00 0.00 -2.1 -3.0 -3.5 83.0 83.9 85.0 -4.5 -3.5 -3.0

Sweden 1.4 1.4 1.7 1.7 1.5 1.5 0.00 0.00 0.00 0.5 0.3 0.4 37.0 35.0 34.0 3.0 3.5 3.0

Norway 2.5*** 1.5*** 1.7*** 2.2 2.0 2.2 1.50 1.50 1.50 7.0 7.0 6.0 40.0 40.0 40.0 6.5 7.0 6.0

Switzerland 0.8 0.6 0.7 0.4 0.1 0.2 -0.75 -0.75 -0.75 0.6 0.4 0.5 40.5 39.8 38.9 9.7 9.1 9.3

Others

China 6.2 5.9 5.7 2.3 2.5 2.9 4.35 4.35 4.35 -6.0 -6.2 -6.1 55.0 59.0 65 1.0 0.9 0.7

Japan 0.9 0.2 0.7 0.6 1.0 0.4 -0.10 -0.10 -0.10 -3.0 -2.7 -2.5 238.0 237.0 237.0 3.3 3.3 3.2

*Annual averages, except for CEE countries, for which end-of-period numbers are used.**Non-wda figures. Adjusted for working days: 0.6% (2019), 0.3% (2020) and 0.8% (2021). Source: UniCredit Research ***Mainland economy figures. Overall GDP: 1.5% (2019), 1.2% (2020) and 1.5% (2021).




Table 2: Quarterly GDP and CPI forecasts

REAL GDP (% QOQ, SA)

3Q19 4Q19 1Q20 2Q20 3Q20 4Q20 1Q21 2Q21 3Q21 4Q21

US (annualized) 1.9 1.6 1.2 0.7 -0.2 -0.1 1.1 1.5 1.5 1.9

Eurozone 0.2 0.2 0.3 0.2 0.1 0.1 0.2 0.3 0.3 0.4

Germany 0.1 0.1 0.2 0.1 0.0 0.0 0.2 0.3 0.4 0.4

France 0.3 0.2 0.3 0.3 0.2 0.1 0.3 0.3 0.3 0.4

Italy 0.1 0.1 0.1 0.1 0.0 0.0 0.1 0.2 0.2 0.2

Spain 0.4 0.4 0.4 0.3 0.3 0.3 0.4 0.4 0.4 0.4

Austria 0.1 0.2 0.3 0.3 0.2 0.2 0.3 0.4 0.4 0.4

CEE

Poland (% yoy) 3.9 3.7 3.7 3.4 3.4 2.4 2.7 2.7 3.7 4.1

Czechia 0.3 0.0 0.6 0.7 0.6 0.6 0.3 0.4 0.6 0.6

Hungary (% yoy) 5.0 4.2 3.4 3.1 2.4 2.0 1.7 2.6 3.3 3.8

Russia 0.8 0.4 0.3 0.2 -0.1 -0.2 0.3 0.5 0.6 0.6

Turkey (% yoy) 1.0 3.7 3.0 2.3 2.1 1.7 2.0 2.6 3.0 4.4

Other Europe

UK 0.3 0.2 0.3 0.2 0.1 0.3 0.1 0.3 0.3 0.3

Sweden 0.4 0.4 0.4 0.4 0.3 0.3 0.4 0.5 0.5 0.6

Norway (mainland) 0.7 0.5 0.3 0.3 0.2 0.2 0.5 0.5 0.6 0.7

Switzerland 0.2 0.2 0.2 0.1 0.1 0.0 0.2 0.2 0.3 0.4

CPI INFLATION (% YOY)

3Q19 4Q19 1Q20 2Q20 3Q20 4Q20 1Q21 2Q21 3Q21 4Q21

US 1.8 2.0 2.2 1.9 1.5 1.2 1.3 1.4 1.5 1.6

Eurozone 1.0 1.0 1.3 0.9 0.8 0.9 0.9 1.1 1.3 1.2

Germany 1.4 1.3 1.7 1.5 1.2 1.2 1.3 1.5 1.7 1.6

France 1.0 1.0 1.3 1.1 1.0 1.0 1.0 1.2 1.3 1.3

Italy 0.4 0.4 0.6 0.7 0.6 0.7 0.6 0.7 0.8 0.9

Spain (HICP) 0.4 0.7 1.2 0.8 0.7 0.9 1.0 1.1 1.2 1.2

Austria 1.4 1.2 1.4 1.5 1.6 1.6 1.6 1.7 1.9 2.0

CEE

Poland (EoP) 2.6 2.9 3.6 2.5 2.9 2.9 2.4 2.3 2.3 2.5

Czechia 2.7 2.7 2.7 2.5 2.5 2.4 2.1 2.1 2.1 2.1

Hungary 2.8 3.8 3.8 3.4 3.2 3.2 2.9 3.1 3.1 3.3

Russia 4.0 3.3 2.7 2.8 3.3 3.5 3.5 3.5 3.8 4.0

Turkey 9.3 11.7 11.9 11.4 9.3 9.6 10.0 10.5 9.7 8.9

Other Europe

UK 1.8 1.5 1.5 1.3 1.3 1.2 1.3 1.4 1.5 1.6

Sweden 1.4 1.5 1.4 1.5 1.5 1.5 1.5 1.5 1.5 1.5

Norway 1.6 1.7 1.8 2.0 2.1 2.1 2.2 2.2 2.1 2.1

Switzerland 0.3 0.1 0.2 0.1 0.1 0.1 0.0 0.0 0.3 0.3

Source: UniCredit Research

Table 3: Oil forecasts

Current 1Q20 2Q20 3Q20 4Q20 1Q21 2Q21 3Q21 4Q21

Brent (USD/bbl, average) 62 63 58 53 55 55 58 58 58





Table 4: Comparison of annual GDP and CPI forecasts

GDP (%)

UniCredit IMF (Oct-19)

European Commission (Nov-19)

OECD (Nov-19)

2019 2020 2021 2019 2020 2021 2019 2020 2021 2019 2020 2021

World 3.0 2.7 3.2 3.0 3.4 3.6 2.9 3.0 3.1 2.9 2.9 3.0

US 2.3 1.1 0.9 2.4 2.1 1.7 2.3 1.8 1.6 2.3 2.0 2.0

Eurozone 1.2 0.8 1.0 1.2 1.4 1.4 1.1 1.2 1.2 1.2 1.1 1.2

Germany 0.6* 0.7* 0.8* 0.5 1.2 1.4 0.4 1.0 1.0 0.6 0.4 0.9

France 1.3 1.0 1.1 1.2 1.3 1.3 1.3 1.3 1.2 1.3 1.2 1.2

Italy 0.2 0.2 0.5 0.0 0.5 0.8 0.1 0.4 0.7 0.2 0.4 0.5

Spain 1.9 1.4 1.5 2.2 1.8 1.7 1.9 1.5 1.4 2.0 1.6 1.6

Austria 1.5 1.0 1.3 1.6 1.7 1.6 1.5 1.4 1.4 1.5 1.3 1.3

Greece 1.6 1.9 2.1 2.0 2.2 1.7 1.8 2.3 2.0 1.8 2.1 2.0

Portugal 1.9 1.5 1.5 1.9 1.6 1.5 2.0 1.7 1.7 1.9 1.8 1.7

CEE

Poland 4.1 3.2 3.4 4.0 3.1 2.7 4.1 3.3 3.3 4.3 3.8 3.0

Czechia 2.4 1.9 2.0 2.5 2.6 2.6 2.5 2.2 2.1 2.6 2.1 2.3

Hungary 4.8 2.7 2.9 4.6 3.3 2.9 4.6 2.8 2.8 4.8 3.3 3.1

Russia 1.1 1.1 1.4 1.1 1.9 2.0 1.0 1.4 1.5 1.1 1.6 1.4

Turkey 0.3 2.2 3.1 0.2 3.0 3.0 0.3 3.1 3.5 0.3 3.0 3.2

Other Europe

UK 1.3 0.8 0.9 1.2 1.4 1.5 1.3 1.4 1.4 1.2 1.0 1.2

Sweden 1.4 1.4 1.7 0.9 1.5 2.1 1.1 1.0 1.4 1.4 1.2 1.2

Norway 2.5** 1.5** 1.7** 1.9 2.4 1.6 1.6 1.9 1.9 2.5 2.0 1.7

Switzerland 0.8 0.6 0.7 0.8 1.3 1.6 1.0 1.6 1.3 0.8 1.4 1.0

Others

China 6.2 5.9 5.7 6.1 5.8 5.9 6.1 5.8 5.6 6.2 5.7 5.5

Japan 0.9 0.2 0.7 0.9 0.5 0.5 0.9 0.4 0.6 1.0 0.6 0.7

CPI INFLATION (%)***

UniCredit IMF (Oct-19)

European Commission (Nov-19)

OECD (Nov-19)

2019 2020 2021 2019 2020 2021 2019 2020 2021 2019 2020 2021

US 1.8 1.7 1.5 1.8 2.3 2.4 1.8 2.1 2.0 1.8 2.2 2.2

Eurozone 1.2 1.0 1.1 1.2 1.4 1.5 1.2 1.2 1.3 1.2 1.1 1.4

Germany 1.4 1.4 1.5 1.5 1.7 1.7 1.3 1.2 1.4 1.3 1.2 1.5

France 1.1 1.1 1.2 1.2 1.3 1.4 1.3 1.3 1.3 1.3 1.2 1.3

Italy 0.6 0.7 0.8 0.7 1.0 1.1 0.6 0.8 1.1 0.6 0.6 1.2

Spain 0.9 0.9 1.1 0.7 1.0 1.4 0.9 1.1 1.4 0.8 1.1 1.3

Austria 1.5 1.5 1.8 1.5 1.9 1.9 1.5 1.6 1.6 1.5 1.6 1.7

Greece 0.3 0.5 0.8 0.6 0.9 1.3 0.5 0.6 0.9 0.4 0.4 0.9

Portugal 0.2 0.5 0.7 0.9 1.2 1.3 0.3 1.1 1.4 0.3 0.5 1.0

CEE

Poland 2.9 2.9 2.5 2.4 3.5 3.4 2.2 2.6 2.5 2.3 2.9 2.8

Czechia 2.8 2.5 2.1 2.6 2.3 2.0 2.6 2.3 2.0 2.8 2.5 2.3

Hungary 3.8 3.2 3.3 3.4 3.4 3.3 3.4 3.1 3.0 3.3 3.4 4.1

Russia 3.3 3.5 4.0 4.7 3.5 3.9 4.5 3.7 4.0 4.9 4.0 4.0

Turkey 11.7 9.6 8.9 15.7 12.6 12.4 15.3 10.3 9.3 15.8 13.2 10.0

Other Europe

UK 1.8 1.3 1.5 1.8 1.9 2.0 1.8 2.0 2.2 1.9 2.0 1.8

Sweden 1.7 1.5 1.5 1.7 1.5 1.6 1.7 1.5 1.6 1.8 1.8 1.8

Norway 2.2 2.0 2.2 2.3 1.9 2.0 2.3 2.0 2.0 2.3 2.0 2.2

Switzerland 0.4 0.1 0.2 0.6 0.6 0.9 0.8 1.3 1.3 0.4 0.4 1.0

Others

China 2.3 2.5 2.9 2.3 2.4 2.8 - - - 2.5 2.2 1.9

Japan 0.6 1.0 0.4 1.0 1.3 0.7 0.5 1.1 0.7 0.6 1.1 1.2

*Non-wda figures. Adjusted for working days: 0.6% (2019), 0.3% (2020) and 0.8% (2021); **Mainland economy figures. Overall GDP: 1.5% (2019), 1.2% (2020) and 1.5% (2021); ***Annual averages, except for CEE countries, for which end-of-period numbers are used. Source: IMF, European Commission, OECD, UniCredit Research




Table 5: FI forecasts

INTEREST RATE AND YIELD FORECASTS (%)

Current 1Q20 2Q20 3Q20 4Q20 1Q21 2Q21 3Q21 4Q21

EMU

Refi rate 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Depo rate -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50 -0.50

3M Euribor -0.41 -0.40 -0.40 -0.40 -0.40 -0.40 -0.40 -0.40 -0.40

2Y Schatz -0.64 -0.60 -0.65 -0.70 -0.70 -0.60 -0.60 -0.50 -0.50

fwd -0.67 -0.67 -0.68 -0.67 -0.66 -0.65 -0.64 -0.62

5Y Obl -0.58 -0.55 -0.60 -0.70 -0.70 -0.60 -0.50 -0.35 -0.20

10Y Bund -0.35 -0.35 -0.40 -0.50 -0.50 -0.35 -0.20 0.00 0.20

fwd -0.31 -0.29 -0.26 -0.24 -0.22 -0.20 -0.18 -0.16

30Y Bund 0.18 0.15 0.05 -0.10 -0.10 0.10 0.25 0.50 0.70

2/10 29 25 25 20 20 25 40 50 70

2/5/10 -18 -15 -15 -20 -20 -25 -20 -20 -10

10/30 52 50 45 40 40 45 45 50 50

2Y EUR swap -0.34 -0.30 -0.35 -0.40 -0.40 -0.30 -0.30 -0.20 -0.20

5Y EUR swap -0.23 -0.20 -0.25 -0.35 -0.35 -0.25 -0.15 0.00 0.15

10Y EUR swap 0.07 0.00 -0.10 -0.25 -0.25 -0.05 0.15 0.35 0.55

US

Fed Fund 1.75 1.50 1.25 1.00 0.75 0.75 0.75 0.75 0.75

3M Libor 1.89 1.40 1.15 0.90 0.75 0.75 0.80 0.85 0.85

2Y UST 1.57 1.40 1.20 1.10 1.00 1.05 1.15 1.20 1.30

fwd 1.58 1.58 1.58 1.59 1.59 1.59 1.59 1.59

5Y UST 1.58 1.50 1.40 1.35 1.30 1.45 1.60 1.80 2.00

10Y UST 1.74 1.70 1.60 1.55 1.50 1.70 1.90 2.20 2.50

fwd 1.78 1.81 1.83 1.85 1.88 1.90 1.92 1.94

30Y UST 2.20 2.20 2.10 2.10 2.05 2.25 2.40 2.70 3.00

2/10 16 30 40 45 50 65 75 100 120

2/5/10 -15 -10 0 5 10 15 15 20 20

10/30 46 50 50 55 55 55 50 50 50

2Y USD swap 1.56 1.50 1.30 1.25 1.15 1.20 1.30 1.35 1.45

10Y USD swap 1.63 1.65 1.55 1.55 1.50 1.70 1.90 2.20 2.50

UK

Key rate 0.75 0.50 0.25 0.00 0.00 0.00 0.00 0.00 0.00

Spreads Current 1Q20 2Q20 3Q20 4Q20 1Q21 2Q21 3Q21 4Q21

10Y UST-Bund 208 205 200 205 200 205 210 220 230

10Y BTP-Bund 155 125 135 150 150 150 150 150 150

10Y EUR swap-Bund 42 35 30 25 25 30 35 35 35

10Y USD swap-UST -11 -5 -5 0 0 0 0 0 0





Table 6: FX forecasts

EUR Current 1Q20 2Q20 3Q20 4Q20 1Q21 2Q21 3Q21 4Q21

G10

EUR-USD 1.11 1.13 1.14 1.15 1.16 1.16 1.17 1.18 1.18

EUR-CHF 1.10 1.11 1.12 1.13 1.13 1.13 1.14 1.15 1.15

EUR-GBP 0.86 0.87 0.87 0.86 0.86 0.85 0.85 0.85 0.84

EUR-JPY 120 124 123 122 122 122 122 122 120

EUR-NOK 10.14 10.00 9.95 9.90 9.85 9.80 9.75 9.70 9.65

EUR-SEK 10.69 10.55 10.50 10.45 10.40 10.35 10.30 10.25 10.20

EUR-AUD 1.62 1.66 1.70 1.74 1.78 1.73 1.70 1.66 1.62

EUR-NZD 1.72 1.79 1.84 1.89 1.93 1.87 1.83 1.79 1.74

EUR-CAD 1.47 1.49 1.53 1.55 1.58 1.55 1.54 1.53 1.51

EUR-TWI 96.8 99.1 99.3 99.6 99.9 99.9 100.7 101.0 101.0

CEEMEA & CHINA

EUR-PLN 4.29 4.32 4.30 4.29 4.30 4.29 4.35 4.30 4.30

EUR-HUF 333 332 327 333 335 328 332 336 340

EUR-CZK 25.6 25.5 25.5 25.5 25.4 25.4 25.4 25.3 25.3

EUR-RON 4.78 4.83 4.84 4.82 4.85 4.92 4.93 4.92 4.95

EUR-TRY 6.33 6.45 6.56 6.84 7.17 7.32 7.46 7.61 7.76

EUR-RUB 70.8 74.8 76.3 78.0 79.3 80.9 82.1 83.1 83.1

EUR-ZAR 16.4 16.7 16.8 16.9 16.9 16.9 17.0 17.1 17.0

EUR-CNY 7.78 7.97 7.98 7.99 8.00 8.06 8.19 8.26 8.32

USD Current 1Q20 2Q20 3Q20 4Q20 1Q21 2Q21 3Q21 4Q21

G10

EUR-USD 1.11 1.13 1.14 1.15 1.16 1.16 1.17 1.18 1.18

USD-CHF 0.99 0.98 0.98 0.98 0.97 0.97 0.97 0.97 0.97

GBP-USD 1.29 1.30 1.31 1.33 1.35 1.36 1.37 1.39 1.40

USD-JPY 108 110 108 106 105 105 104 103 102

USD-NOK 9.16 8.85 8.73 8.61 8.49 8.45 8.33 8.22 8.18

USD-SEK 9.66 9.34 9.21 9.09 8.97 8.92 8.80 8.69 8.64

AUD-USD 0.68 0.68 0.67 0.66 0.65 0.67 0.69 0.71 0.73

NZD-USD 0.64 0.63 0.62 0.61 0.60 0.62 0.64 0.66 0.68

USD-CAD 1.33 1.32 1.34 1.35 1.36 1.34 1.32 1.30 1.28

USTW$ 92.4 91.4 91.3 90.8 90.5 89.9 89.0 87.9 87.3

DXY 97.9 96.6 95.8 95.0 94.2 93.9 93.1 92.2 91.8

CEEMEA & CHINA

USD-PLN 3.88 3.82 3.77 3.73 3.71 3.70 3.72 3.64 3.64

USD-HUF 301 294 287 290 289 283 284 285 288

USD-CZK 23.1 22.6 22.4 22.2 21.9 21.90 21.70 21.40 21.40

USD-RON 4.31 4.27 4.25 4.19 4.18 4.24 4.21 4.17 4.19

USD-TRY 5.71 5.71 5.75 5.95 6.18 6.31 6.38 6.45 6.58

USD-RUB 64.0 66.2 66.9 67.8 68.4 69.7 70.2 70.4 70.4

USD-ZAR 14.79 14.75 14.70 14.65 14.60 14.55 14.50 14.45 14.40

USD-CNY 7.03 7.05 7.00 6.95 6.90 6.95 7.00 7.00 7.05

Forecasts are end-of-period Source: Bloomberg, UniCredit Research




Table 7: Risky assets forecasts

EQUITY AND CREDIT FORECASTS

Current Mid-2020 End-2020

Equities

Euro STOXX 50 3680 3400 3850

DAX 13150 12000 14000

MSCI Italy 63 58 67

Credit

iBoxx Non-Financials Senior 55 60 60

iBoxx Financials Sen 54 60 60

iBoxx High Yield NFI 350 400 450

Source: Bloomberg, Markit iBoxx, UniCredit Research



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